Why Kids Should Open IRA Accounts

Posted by Christian Wynns on June 16th, 2016

Convincing your kids to use their summer earnings to invest in an IRA is a pretty tough sell. But it’s an excellent idea and one that might not be too outlandish if you encourage your child simply to allocate a portion of his or her earnings to the cause. Not only will modest contributions add up to significant savings come retirement, but it’s also a way to teach your child an invaluable lesson that is unlikely to be learned in school.

Opening an IRA account also provides a chance to teach your kids about stocks, mutual funds and the basics of investing. And even relatively small contributions can add up big over the long haul. Say your teenage child pays $1,000 into an IRA each year for three years, starting this year. After 45 years, the account would be worth $39,005 assuming a 6% annual return. Bump that up to $1,500 for each of the three years and the IRA would be worth $58,508 in 45 years. Not bad for mowing a few lawns.

The Basics

All that’s required to make an IRA contribution is earned income. Until you turn 70 1/2, age is irrelevant. So if your child earns some money this summer from cleaning pools, dog sitting, working as an employee of your small business or whatever, he or she is entitled to make an IRA contribution for the 2016 tax year.

Specifically, for 2016, your child can contribute the lesser of:

* Earned income for the year or

* $5,500

Your child can contribute to either a traditional IRA or a tax-free Roth IRA. The contribution limits are the same for both types of accounts.

The Roth IRA Is the Way to Go

For a kid, the Roth IRA is usually better because contributions can be withdrawn at any time without any tax hit.  And, up to $10,000 of earnings can be taken out tax-free by the child to buy a first home. That said, earnings generally cannot be withdrawn before age 59 1/2 without triggering income taxes and a 10% penalty.

Another reason to forego the traditional IRA is because your child may not actually be entitled to any tax deductions for his contributions. Why? Because an unmarried dependent kid’s standard deduction automatically shelters up to $6,300 of earned income for 2016. So unless your child’s job pays more than $6,300 or he had income from other sources (like dividends and capital gains from a trust fund or custodial account), contributing to a traditional IRA won’t generate any current tax savings.

Finally, the fact that your child owns an IRA (Roth or traditional) won’t cause him or her to lose out on any financial aid benefits at college time because IRAs don’t count as assets.

You can also help your child or grandchild by making a contribution to the Roth IRA for them this year. You can put in up to $5,500 (but the amount can not exceed the child’s 2016 earnings) and your payin counts toward your $14,000 ($28,000 if filing jointly) gift tax exclusion.

If You’re Self-Employed, Hire Your Kid

If you run a small business as a sole proprietorship or husband-wife partnership, hiring your under-age-18 child as a part-time employee of your business can be good for both you and the kid. Here’s why:

* Your child can contribute to a Roth IRA.

* If the kid is under 18, his or her wages are exempt from Social Security, Medicare and Federal Unemployment taxes. (This loophole applies equally to single-member LLCs treated as sole proprietorships for federal tax purposes and husband-wife LLCs treated as husband-wife partnerships.)

* You can deduct your child’s wages as a business expense, which lowers both your income and self-employment tax bills. If you live in a state with a personal income tax, it lowers your state income tax bill too.

* For 2016, the first $6,300 of your child’s wages is sheltered from the federal income tax by the kid’s standard deduction (assuming there is no other income).

If your small business is set up as a corporation, your kid’s wages are subject to Social Security, Medicare and Federal Unemployment taxes, regardless of his age (same as for any garden-variety employee). But you still get the other tax breaks listed above. Although in this case, you deduct the child’s wages as a business expense on your corporation’s income tax return.

Bottom line: Hiring your child is one of the most tax-smart things anyone can do. Just remember to pay a wage that is reasonable for the work done, keep proper time records, and take care of those W-2s just like you would for any other employee.

See you local tax advisor for more information.

Source:  Bill Bischoff, MarketWatch