The ins and outs of Roth IRAs for children

By Kelley C. Long, CPA/PFS

It may seem a little premature to start talking about retirement for children before they've even started kindergarten, but funding a Roth IRA for kids could arguably be a better financial planning move for their futures than saving into a Sec. 529 education savings plan.

Coupled with the ability to use Roth funds to pay qualified education expenses without incurring early withdrawal penalties (or tax, so long as the withdrawals are from prior contributions), starting a Roth for a child can be a more flexible way to take advantage of the miracle of compounding in the early years, before it's certain that the child will need funds to pay for college.

Although the strategy has limitations, here are the key aspects of using a Roth IRA to set children up for future wealth.

Establishing an account

Roth IRAs do not have an age limit, meaning an account can be established for newborns as long as they have a Social Security number and compensation (which includes earned income from self-employment, discussed further below). However, until the child reaches the age of majority (18 in most states, 21 for the rest), the account needs to be set up as a custodial account.

This can be done by any adult, including parents, grandparents, godparents, or even just generous friends. Most of the low-cost investment firms offer custodial Roth IRAs as an option. You'll need the minor's full legal name, Social Security or tax identification number, date of birth, and address to open the account, along with your own information if you intend to be the custodian of the account. Note that regardless of the account custodian, any funds contributed on the minor's behalf will count against the contributor's annual gift tax exclusion.

Beneficiary designations are typically not allowed until children reach majority, when they are able to name the beneficiary of their choice. Accounts without beneficiaries pay to the minor's estate should the unthinkable happen. Like any other custodial account, upon the child's reaching the age of majority, the account should be turned over to the child according to the laws of the custodian's state — all funds contributed are irrevocable and legally belong to the child.

Establishing earned income

While there are no age requirements to open a Roth IRA for a child, there must be compensation to support any contributions. Total contributions to any IRA may not exceed the child's compensation in the year of the contribution, up to the annual limit for account holders under age 50.

Compensation can have a broader definition than just W-2-based income. It also includes earned income from self-employment.

However, as Caron Mitchell, CPA, CGMA, and owner of her own Tucson, Ariz.-based tax and accounting firm, said: "The ideal is when one of the parents owns a sole proprietorship (or the parents together have a partnership) and can employ the child. In that scenario, the child should be added to payroll, but they would [also] meet the exception for Social Security and Medicare." (See also "Hiring Family Members in a Small Business," JofA, June 2, 2022.)

Outside that option, Mitchell said that the child can look to third parties for paying work — baby-sitting, leaf raking, being a parent's helper, etc. Newborns who can't yet contribute much beyond sleep deprivation may even be able to earn, typically, via modeling or acting gigs.

Additionally, Mitchell noted that money paid for family chores generally doesn't count, mostly because paying for chores gets into the murky parenting debate around allowance and whether children should be paid to help out around the house or be expected to contribute as part of the family regardless. It's best to look to earnings opportunities either outside the house or for tasks that go above and beyond the day-to-day contributions of running a household.

Teaching kids the value of hard work early on

It's worth noting that anyone can contribute to another person's Roth IRA, as long as the account owner has the earned income to support the contribution. In this way, a parent or other adult can make the contributions to the Roth IRA as a gift to the child while allowing the child to keep the money earned and use it for enjoyment. This helps the child to begin learning the value of working hard for an income without yet having to accept one of the downsides of adulthood, which is the pain of needing to save for a rainy day while delaying the gratification from that hard work.

Documenting earned income and taxes

Beyond earning compensation, some documentation is required, including, most likely, filing a tax return for each year that Roth IRA contributions are made. As Mitchell notes, recordkeeping "doesn't need to be complex, but they (or the parent) should at least keep a spreadsheet." Payment apps like Apple Pay or Venmo can help with this as well. She also recommended filing a tax return, regardless of the filing requirement, when contributing to a Roth IRA.

For income earned that's not reported on a Form W-2, Wage and Tax Statement, self-employment tax may come into play. Mitchell pointed out that "earned income other than from an employer is considered self-employment, regardless of how casual it is or how much income is earned." An individual must pay self-employment tax if he or she had net earnings of $400 or more as a self-employed person.

Earnings should also reflect the work being done. This is especially true when the child is doing work for a family-owned business. It's perhaps feasible that a child could be paid $6,000 for a day on the set for a local business photo shoot, but the IRS is likely to take issue with paying $1,000 for a day of making copies, regardless of how many paper cuts the child ends up nursing.

Above all, opening and funding a Roth IRA for children can be an excellent way to start children on a journey toward a lifetime of financial well-being by pairing opportunities to teach the value of hard work with the unmatched benefit of the time value of money invested early in life. Just be sure to properly document earned income to support any contributions made.

Kelley C. Long, CPA/PFS, CFP, is a personal financial coach in Arizona. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.

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