Please send this post to your accountant. Perhaps kids’ Roth IRAs are unusual because parents don’t realize it can be done!
In our case, it wasn’t just about the money. It turned out to be long-range planning– both financially and for raising a money-smart kid.
Before I get into the details and how you can do the same for your kid, let me address two very common concerns:
- All of this is perfectly legal. Like any other tax planning, starting your kid’s Roth IRA will only trigger an IRS audit if you get greedy. I’ve included the references so that you can check them against your situation and with your own accountant.
- The federal government and the college financial aid offices will not penalize your family or your child for having a Roth IRA. The reality is that you’re “penalized” even more for putting assets into a 529 account or a kid’s trust– although those are good tools too.
I’ll admit it up front: we parents made our plans on the fly. When our daughter came up with an idea, we’d figure out a way to sneak in a life lesson while helping her turn her idea into reality. Other times I’d stumble across an idea, research it, and then tweak it to motivate our daughter. If you start a Roth IRA for your kid then you‘re also responsible for teaching them how to use it. They’re not ready for IRS Publication 590 but they’re certainly ready to learn about jobs and saving money. By the time they’re old enough to figure out how to cash in their Roth IRA in for a BMW, you’ve also taught them why that’s a horrible idea.
What we did
It all started in first grade. Our daughter was a good student, but she didn’t like homework.
Luckily her elementary school had a Kumon franchise on the premises. After the school day ended she’d see several of her friends trot over there (with their cool Kumon worksheets & backpacks) for tutoring on their math & reading exercises. It was an exclusive club! One day she told us that she was having problems understanding her numbers and she needed to go to Kumon to learn better math. Our kid was asking for more school.
It seemed like a good idea at an affordable price. Here‘s the “parenting on the fly” part: we told our daughter she wasn’t ready to do Kumon. Kumon has homework every. single. day.but she didn’t want to do her school homework. She would have to do better on her school homework before she could start Kumon.
The homework battles immediately disappeared (she really wanted to go to Kumon with her friends) and next week she picked up her own set of cool Kumon gear. She did Kumon almost constantly until she graduated from high school. It’s one of the key accomplishments that got her into a top-10 engineering university with a full tuition scholarship. Those monthly Kumon fees were a drag on the budget but they had a huge return on the college fund.
Kumon also has role models: the owner and her employees. We kept pointing out that the owner was running her own business, and she used our fees to pay the teen tutors. As our daughter got older, she dreamed about opening her own Kumon business. Even better, the teen tutors were getting paid over $7/hour to show her how to do algebra.
The day our daughter turned 14 and could get a work permit, she started her part-time job at a Kumon tutoring center. She’s earned over $2500 per year every year since then.
Starting the Roth IRA account
Our daughter started her Roth IRA with W-2 earned income, and she earned more through family labor: rehabbing our rental property, washing cars, yardwork, babysitting, even “apprentice” labor on wiring electrical sockets and fixing toilets. If we could figure out a way to pay her for work then we added it to her Roth IRA.
I researched articles about setting up a kid’s Roth IRA. (More recent articles are linked in the “Related articles” section at the bottom of this post.) IRS Publication 15 says that parents paying their children under 21 as “family employees” don’t even need to create W-2s or 1099-MISCs. (See Chapter 3 on page 12 of that link.) I kept payment records in Quicken (along with all of our other family spending) so we have the data if necessary. TurboTax never complained about the tax rules– in fact it encouraged her to set up a Roth IRA with her earnings.
The biggest challenge was finding an investment firm that would sub-custody a Roth IRA for a minor. I talked with several companies before T. Rowe Price agreed to open an account in her name with me as the adult custodian. (TRP’s funds also had higher expense ratios and quarterly fees, so today I’d probably start with Vanguard.) As soon as our daughter turned 18 she moved her Roth IRA to Fidelity (for their Spartan fees).
The intangible benefits of a kid’s Roth IRA
Education became an important part of the Roth IRA when our daughter spent her first Kumon paycheck on her own cell phone. She pointed out that she was missing plenty of teen networking about homework and study groups, and her new cell phone solved that problem for about $20/month. It also taught her how many hours she’d have to work to pay for her needs & wants.* She learned tricks about cheap calls and texts and applied that frugal attitude to her entire budget. She really enjoyed the phone, but she was keenly aware how quickly it would chew through her paycheck.
We taught her about saving for retirement. That motivation was easy: if she wanted to retire in her 40s like her parents, then she needed to start a Roth IRA now. We also talked about how her Roth IRA would compound if she maximized her contributions, and we even built a spreadsheet to play with the numbers. After a few of those talks, she agreed to put as much as she could into her Roth IRA and we parents agreed to match some of her contributions. She still had to earn the income from her Kumon work and side-hustle jobs to be able to put it into her Roth IRA, but she got to keep enough of it to stay motivated. By the time she finished high school she was maximizing her Roth IRA contributions.
Two important points helped her stay motivated: she loved her Kumon work and she had good mentors. She was teaching young kids, making friends with the other tutors, and treated very well by her boss. We parents showed her that she could retire in her 40s, and she saw plenty of “negative” adult financial behavior.
Her Roth IRA education would have been much more difficult if she was cleaning toilets at the movie theater while we parents were setting poor financial examples. She also knew how many hours she’d have to work to buy a Macbook, so it helped her control her spending. Her attitude was not “Yay, I have $20K in my Roth IRA– let’s go car shopping!” Her behavior was “I worked for hundreds of hours to get this money, and I’m not going to waste it.” There was plenty of teen socializing on the beach, not so much at Starbucks.
During 2008-09 she learned a powerful lesson about investing in volatile markets. She was quite upset to watch her S&P500 index fund drop over 40%, but it gave us plenty of opportunities to talk about the family finances (her investments were doing better than ours!) and to use dollar-cost averaging. She lived through a recession and got plenty of financial reassurance at a very impressionable age, and she didn’t have to pay fees to an advisor. Today when the markets go down, she cheers with Warren Buffett about equities on sale.
Other details you need to know
Earned income can come from just about any source, and at almost any age. I’ve read of babies and young kids being paid as photo models with W-2 or 1099 income. Another parent paid a modeling fee to his kids for using their photos in promotional brochures for his business. I’ve read of teens recording videos (makeup techniques, video game skills) and earning advertising share from their YouTube channel– either in their own name at age 18 or as an employee in the family business.
A local friend pays his kids out of his own pocket to set up and run websites for his side-hustle businesses. Teens who enjoy writing or blogging can build an audience on a popular teen topic and run advertising. (Google AdSense requires a publisher to be at least 18 years old, Amazon Associates will not market to children younger than 13, and other media companies may have similar restrictions.) There’s always the traditional lawn-mowing, car washing, dog walking, and snow-shoveling businesses.
IRS Publication 929 lists the requirements for filing a child’s tax return. Your child may not reach the filing threshold, but if any of their W-2 income was withheld then they’ll want to file a return to obtain a refund. A tax return also documents their earned income in case the IRS has questions about their Roth IRA. Tax software makes it very easy to fill out a return, and your teen can do it with your help. They also can see exactly what they earned and how much goes to the government, which helps them remember the tax consequences of their earning & investing decisions.
Ideally a child would maximize every Roth IRA contribution and let it compound for decades. However, a Roth IRA can help save for college, and it’s more useful than a 529 if your child decides not to go to college. A teen’s Roth IRA will not affect the family’s eligibility for financial aid because retirement accounts are not included in the calculation. College financial aid programs will generally assess other student’s assets at 20%-25% per year for their expected financial contribution, but their Roth IRA is not included in this formula. The contributions to a Roth IRA can be withdrawn at any time for any reason without additional tax or penalties (whether it’s for textbooks or a cup of coffee), and Roth IRA earnings can be withdrawn penalty-free for educational expenses. Be careful with these decisions, though– a student’s withdrawals from an IRA could be considered as income that would count against their financial aid for the following year. It’s best to avoid using the Roth IRA for college expenses, and it’s even better to keep contributing to it.
One of the first financial chores for a college graduate is setting up their own emergency fund. Instead of leaving that emergency fund in a checking account or a “high-yield” savings account, they can contribute it to their Roth IRA. Contributions can be withdrawn any time for any reason, so they can put the money to work (perhaps in a bond fund or a blue-chip stock fund) and still sleep comfortably at night knowing that they can tap an emergency fund.
On their own
When our daughter started college, she kept on working. (As far as I know, work came after she finished her homework & studying!) She enjoyed giving campus tours ($12/hour, documented on a 1099-MISC) and during winter/summer breaks she’d rack up more hours at Kumon. She kept doing jobs and projects around the house with us, too, so she kept reporting it on her tax returns. We parents kept matching her contributions during college (as long as she had the earned income) so that she could maximize her Roth IRA while still having some spending cash. When she turned 21 years old, however, she aged out of the “family employee” category.
Yes, she eventually bought a car. But she didn’t touch her Roth IRA.
When she starts her new job after graduation, you know that she’ll be maximizing the contributions to her retirement accounts. She’s also very focused on how long it’ll take her to reach financial independence, and her Roth IRA puts a great foundation in place to reach that goal at a younger age than her parents.
[* She convinced us that a cell phone is a tool. We bought her an iPhone for her 17th birthday and we’ve footed that bill during college. It’s absolutely essential on campus.]
By: Doug Nordman