We’ll cover legitimate ways minors can have a Roth IRA and take advantage of its massive tax-saving benefits.
Laura answers a listener’s question about the Roth IRA rules for his minor kids and how to pay them and correctly report the income for working in his business.
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“Hello, Laura. I own a small business, and I currently have no employees. My kids have done work for my business for many years. I've always paid them a few dollars and noted it as contract labor as I did with anyone else. Last year, I paid my youngest $1,200, and she contributed it to a Roth IRA. She's in college and has a scholarship of $4,000. My questions are:
I enjoy your show and look forward to hearing back from you. My name is Tony.”
Thanks for your voice message and great questions, Tony! I love that you’re exploring ways your kids can invest for their futures using Roth IRAs.
If you also have kids or plan on becoming a parent someday, and want to help them grow rich, stay with me! We’ll cover Tony’s questions and legitimate ways minors can have a Roth IRA and take advantage of its massive tax-saving benefits.
Hey, everyone, and welcome back to Money Girl—I'm so glad you're spending some time with me! If you're a new listener, my name is Laura Adams. I'm an award-winning author and finance expert who's been bringing money tips and advice weekly on this podcast since 2008, with over 40 million downloads.
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What’s an IRA and who can have one?
If you're familiar with a Roth IRA, you know it's a terrific retirement account for after-tax dollars. Unlike a pre-tax, traditional IRA, you don’t get an upfront tax deduction for Roth contributions. But that's great for kids because they typically don't earn enough to owe taxes and, therefore, don't need any tax deductions.
The beauty of a Roth is getting tax-free withdrawals after age 59.5 and not having any required minimum distributions (RMDs). With a traditional account, you must pay income taxes on withdrawals and begin RMDs at age 73 or 75 starting in 2033.
In addition, you can withdraw your Roth IRA contributions (but not the earnings) at any time without paying taxes or a penalty. That gives you or your kids a lot of flexibility to tap a Roth IRA for future expenses like a car, college, or wedding. Of course, I recommend staying out of your or your child’s retirement account so it can grow undisturbed and build as much wealth as possible.
You can contribute to a traditional IRA, Roth IRA, or a combination up to your earned income up to the annual limit. For 2023, adults or working minor kids can put earnings of up to $6,500 (or $7,500 if you're over 50) in an IRA. For example, if a minor child earns $7,000, they (or their parents) can contribute up to $6,500 in an IRA. But if you only have $1,200 in earned income, you could only contribute $1,200 to an IRA.
There's no minimum income or age for kids to qualify for an IRA. However, they must have legitimately earned income from employment or self-employment, and we'll talk more about that.
So, let’s discuss what income does and doesn’t count for making IRA contributions. In general, it must come from working, such as wages, salaries, commissions, and tips that get reported in box 1 of Form W-2, Wage and Tax Statement.
Therefore, unless you have a baby model or a toddler starring in commercials as an employee or a self-employed person, it’s not likely that very young children could qualify for a Roth IRA. But it’s common for pre-teens or teenagers with after-school or summer jobs to make enough W-2 money to contribute to or max out an IRA.
In addition, kids qualify for an IRA if they have net earnings from their own business, like babysitting, tutoring, or dog walking. But you can't pay a child a large cash allowance for household chores and call it income for IRA purposes without documenting and claiming it as business income.
The following are more examples of income that do not qualify kids or adults for IRA contributions:
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But what if you're like Tony and have a business where your minor child works? If a child does legitimate, age-appropriate work for a reasonable wage, that qualifies them for an IRA.
However, to count a child's payment from a family business toward their IRA eligibility, it's best to treat them as employees. That means deducting income taxes from their pay and issuing them a W-2. Tony, please don't confuse this with a 1099 for independent contractors, which doesn't require you to withhold taxes from their pay.
I recommend treating your kids as employees because, by definition, you don't manage a contractor or their work directly, which isn't realistic for a minor family member and could get questioned in an audit. If you issue your working kids a W-2 from now on, they'll have undisputed eligibility for making Roth IRA contributions.
If your business is a sole proprietorship, partnership, or LLC, payments to your minor kids are typically not subject to Social Security and Medicare taxes. However, you must withhold income taxes from a minor child's pay. And if your business is a corporation, you must withhold all taxes from a child's payroll regardless of their age.
So, Tony, the tax paperwork you must complete to pay your kids depends on your business's legal entity. And even though it's a slight hassle to withhold income taxes, it's the best way to ensure your kids can legitimately have a Roth IRA.
Tony also asked if his child's scholarship money needs to get reported as income. College scholarship and fellowship funds for undergraduates are generally only taxable if listed in box 1 of Form W-2. So, unless the scholarship is taxable, it doesn't need to be reported but won't count as income for an IRA.
Tony asked how much money his kids have to make before being required to file a tax return. A minor must file a return if their earned income exceeds their standard deduction of $12,950 for 2022 or $13,850 for 2023.
But even if a minor earns less than the standard deduction and doesn't owe any taxes, it's still wise for you to submit a tax return on their behalf. That's because they may qualify for a tax refund of withheld earnings.
For example, a minor working part-time and earning less than $13,850 would owe no income taxes. However, their employer (or parent in a family business) typically withholds taxes from their paychecks throughout the year. To get the money back, the child must file a tax return to trigger a refund payment from the government in the following year.
Minors with self-employment income must file a tax return when their net earnings exceed $400. If you're unsure whether your child should file a tax return or you have questions about paying them in a family business, please get advice from a tax professional, such as a CPA.
ALSO READ: 10 Things Every First-Time Investor Should Know
Parents can help their kids qualify for an IRA by ensuring their income gets properly reported. An IRA contribution could be deemed invalid without verification of legit earned income.
Opening an IRA for a minor at most banks, brokerages, and investment firms is easy. The account will be in your child's name, but you or another adult must manage it until your child turns 18 or 21 in some states. The financial institution may require a minimum amount to get started, such as $50 or $100.
Remember that it doesn't matter where a child's IRA contributions come from, such as a parent's bank account, as long as the child is eligible for them. A parent could let their kids keep all their earned money and make IRA contributions on their behalf. You could even create an incentive where you match the amount a child contributes to their IRA, assuming you don't exceed the current $6,500 limit.
Starting an IRA early in life means your child has lots of time to see it grow into a significant nest egg, even with modest contributions. Imagine you help your child contribute $500 to a Roth IRA every year from age 10 to 20. Even if they never contributed to the account again, it would grow to about $250,000 by their 65th birthday with an 8% average return.
But if your child contributed $1,000 a year at age 20, they would have more than $600,000 in the account. And by contributing $5,000 a year, the account value would exceed $2 million in their mid-60s!
With some foresight, you can put your kids on very successful paths and even raise millionaires by showing them how small, regular investments create financial independence. Thanks again to Tony for inspiring this show with excellent questions!