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We have a lot of parents that ask us if they are allowed to establish a Roth IRA on behalf of their son or daughter.  You can, as long as they have earned income.   This can be a very powerful wealth accumulate strategy for your children since all of the accumulation within the Roth IRA is withdrawal tax free after age 59½.  If your child has $10,000 in their Roth IRA today, assuming they never make another deposit to the account, and it earns 8% per year, 40 years from now the account balance would be $217,000.  Oh, and they don’t pay tax on any of it.

 

Contribution Limits

 

The maximum contribution that an individual under that age of 50 can make to a Roth IRA in 2018 is the LESSER of:

 

  • $5,500
  • 100% of earned income

 

For most children between the age of 15 and 21, their Roth IRA contributions tend to be capped by the amount of their earned income.  The most common sources of earned income for young adults within this age range are:

 

  • Part-time employment
  • Summer jobs
  • Paid internships
  • Wages from parent owned company

 

If they add up all of their W-2’s at the end of the year and they total $3,000, the maximum contribution that you can make to their Roth IRA for that tax year is $3,000.

 

Roth IRA’s for Minors

 

If you child is under the age of 18, you can still establish a Roth IRA for them.  However, it will be considered a “custodial IRA”.   Since minors cannot enter into contracts, you as the parent serve as the custodian to their account.  You will need to sign all of the forms to setup the account and select the investment allocation for the IRA.  It’s important to understand that even though you are listed as a custodian on the account, all contributions made to the account belong 100% to the child.  Once the child turns age 18, they have full control over the account.

 

Age 18+

 

If the child is age 18 or older, they will be required to sign the forms to setup the Roth IRA and it’s usually a good opportunity to introduce them to the investing world.  We encourage our clients to bring their children to the meeting to establish the account so they can learn about investing, stocks, bonds, the benefits of compounded interest, and the stock market in general.  It’s a great learning experience.

 

Contribution Deadline & Tax Filing

 

The deadline to make a Roth IRA contribution is April 15th following the end of the calendar year.  We often get the question:

 

“Does my child need to file a tax return to make a Roth IRA contribution?”

 

The answer is “no”.  If their taxable income is below the threshold that would otherwise require them to file a tax return, they are not required to file a tax return just because a Roth IRA was funded in their name.

 

Distribution Options

 

While many of parents establish Roth IRA’s for their children to give them a head start on saving for retirement, these accounts can be used to support other financial goals as well.  Roth contributions are made with after tax dollars.  The main benefit of having a Roth IRA is if withdrawals are made after the account has been established for 5 years and the IRA owner has obtained age 59½, there is no tax paid on the investment earnings distributed from the account.

 

If you distribute the investment earnings from a Roth IRA before reaching age 59½, the account owner has to pay income tax and a 10% early withdrawal penalty on the amount distributed.  However, income taxes and penalties only apply to the “earnings” portion of the account. The contributions, since they were made with after tax dollar, can be withdrawal from the Roth IRA at any time without having to pay income taxes or penalties.

 

Example:  I deposit $5,000 to my daughters Roth IRA and four years from now the account balance is $9,000.  My daughter wants to buy a house but is having trouble coming up with the money for the down payment.  She can withdrawal $5,000 out of her Roth IRA without having to pay taxes or penalties since that amount represents the after tax contributions that were made to the account. The $4,000 that represents the earnings portion of the account can remain in the account and continue to accumulate tax free.   Not only did I provide my daughter with a head start on her retirement savings but I was also able to help her with the purchase of her first house.

 

We have seen clients use this flexible withdrawal strategy to help their children pay for their wedding, pay for college, payoff student loans, and to purchase their first house.

 

Not Limited To Just Your Children

 

This wealth accumulate strategy is not limited to just your children.  We have had grandparents fund Roth IRA’s for their grandchildren and aunts fund Roth IRA’s for their nephews.   The do not have to be listed as a dependent on your tax return to establish a custodial IRA.

 

If you are funded a Roth IRA for a minor or a college student that is not your child, you may have to obtain the total amount of wages on their W-2 form from their parents or the student because the contribution could be capped based on what they made for the year.

 

Business Owners

 

Sometime we see business owners put their kids on payroll for the sole purpose of providing them with enough income to make the $5,500 contribution to their Roth IRA.  Also, the child is usually in a lower tax bracket than their parents, so the wages earned by the child are typically taxed at a lower tax rate.

 

A special note with this strategy, you have to be able to justify the wages being paid to your kids if the IRS or DOL comes knocking at your door.

 

Michael Ruger

About Michael………

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

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Investment advisory services offered through Greenbush Financial Group, LLC. Greenbush Financial Group, LLC is a Registered Investment Advisor. Securities offered through American Portfolio Financial Services, Inc (APFS). Member FINRA/SIPC. Greenbush Financial Group, LLC is not affiliated with APFS. APFS is not affiliated with any other named business entity. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.