NEW YORK (MainStreet) — Did your dependent son or daughter have a job this summer? Or will he or she be working after-school? You should open a Roth Individual Retirement Account (IRA) for him or her.
If you contribute as much as possible to a Roth IRA account for your children each year from age 16 to age 21, and no other contributions are ever made to the account, it will grow to a substantial six-figure balance by the time they turn 65.
To qualify for an IRA your child must have “earned income” — wages or “net earnings from self-employment.” Money you give your child for doing chores around the house won’t count, but earnings from paper routes, babysitting or mowing lawns can qualify.
You should file a tax return for your child to report such “self-employment” income, whether or not any tax is actually due, to document the income as a basis for making a contribution to a Roth account. Self-employment income can also supplement W-2 wages to increase the Roth contribution.
If you are self-employed, you can put your children on the payroll of your business to generate earned income eligible for a Roth contribution. But be careful – there are special rules you must follow when employing your dependent children. Check with your tax professional before putting your kids on the payroll to make sure you do it right.
You can contribute 100% of your child’s earnings to a Roth IRA, up to a maximum of $5,500 for 2014. If your son earned $2,400 this summer you can contribute $2,400 for him. If he earned $6,500 you can contribute $5,500. This maximum contribution amount increases with inflation in $500 increments.
There is no minimum age or minimum contribution.
While the Tax Code establishes a maximum contribution, there is nothing in the code that says that the money deposited in an IRA for your son or daughter has to come from the actual earnings or even from the child’s funds. Roth contributions can come from any source – from birthday or other gifts made to the child over the years that has been put in savings or from the child’s parents or grandparents.
Invest your children’s Roth monies in a mix of mutual funds to maximize the growth of the account.
There is no tax deduction for contributing to a Roth IRA, but most teenagers don’t need the deduction. Qualified distributions from a Roth will be exempt from federal, and probably state, income tax - assuming, of course, Congress don’t change the law in the future.
You can use a Roth IRA to encourage your children to work or to save. If your son earns $5,000 in a part-time job, open a Roth IRA for him. Or, if your daughter agrees to put $2,500 of her salary from a summer job in a Roth, match it and put in another $2,500.
Since contributions to a Roth are not tax deductible your child can withdraw the contributions at any time without tax or penalty.
But Roth earnings may be taxed and penalized if withdrawn prematurely. Your son can withdraw totally tax and penalty free the contributions made to his ROTH account over the years in the future to use for the down payment on the purchase of a home, with the accrued earnings remaining in the account to continue to grow until retirement.
One caveat - there does exist a potential problem with this idea. Once the child reaches the “age of majority,” usually 18, he or she will have full access to all the funds in the Roth IRA account and can “take the money and run.”
--Written by Robert D. Flach for MainStreet