Building a Child's Roth IRA

This strategy will help children build a savings nest egg in a tax-free Roth IRA. This is one of the best tax-advantaged savings plans available.

If you have children, grandchildren, nieces or nephews of any age, consider helping each child to find employment whereby they will earn at least $6,500 in wages annually. This can be from any legitimate form of employment: babysitting, caring for pets, cutting lawns, lifeguarding, modeling, working at day camps, working at the local supermarket, etc. The child could be compensated as an employee (Form W-2), as a contractor (Form 1099-MISC), or in cash. The income received must be from wages earned; income from interest, dividends and capital gains, and gifts do not qualify as income sources that can be invested in an IRA.

For each year that the child works and has earned income, make a contribution of (up to) $6,000 into a Roth IRA on their behalf. Over a ten-year period, such contributions would grow into a sum of $60,000. If these funds are invested in a Roth IRA that yields an 8% average annual investment return, the value of this account would grow to $93,873 after 10 years. And tax-free! If these funds remain invested in this same Roth IRA for an additional 35 years, without making any additional contributions, the value of this account would grow to a staggering $1,387,757 after 45 years. And tax-free!

The potential growth of a Roth IRA for a teenager is astounding! Even just $1,500 contributed into a Roth IRA each year for only four years will grow to $170,971 after 45 years. And tax-free!

After five years, the (now young adult) child would be able to withdraw the amounts contributed up to that point from their Roth IRA tax-free to use for virtually any purpose, including to help pay for graduate school tuition or towards a down payment on their first home.

The interest, dividends and capital gains income earned in this Roth IRA must remain in the account, where they will continue to grow and compound tax-free until the child reaches retirement age.

Yes, each child will have to file a Federal income tax return each year. However, they will not be subject to any Federal or state income taxes at this level of income. If they are compensated as an employee, they will be subject to Social Security tax of 6.2% plus Medicare tax of 1.45% on their wages earned. On $6,500 of wages, the self-employment tax will amount to $497. If they are compensated as a contractor or in cash, they will be subject to the self-employment tax of 15.3% (i.e., Social Security tax of 6.2% plus Medicare tax of 1.45%, times two) on their wages earned. On $6,400 of earnings, the self-employment tax will amount to $918. This $918 represents the maximum out-of-pocket cost, per child, that would be incurred by pursuing this strategy.

Parents will still be able to claim the child as their dependent on their tax returns.

Lastly, having a Roth IRA will not hurt the child’s chances to receive college financial aid when the time comes for them to apply to college in the future.

I would be happy to discuss this strategy of shifting income to children and setting up Roth IRAs on their behalf with you at your convenience.