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IRAs for Kids

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ByRoy Lewis

We discussed how business owners could reduce their income and self-employment taxes by hiring their children in our article Putting Junior on the Payroll. One side issue discussed in that article was investing in an IRA (either Roth or traditional) for the kids with their earned income. If you haven't had the opportunity to check out that article, now might be the time to do so for background.

Without earned income, a person can't establish an IRA account. So, how do your kids get earned income if you don't have a business and can't hire them directly?

How about having them clean the house?

Huh?

It's certainly possible. It's aggressive... but possible.

How It Works

In effect, you can hire your children to perform household chores, but it's not as easy as you might think. You'll have to mess around with some filing requirements (such as Schedule H attached to your personal tax return), complete some additional reports (such as W-2 forms for the kids), and maybe jump through some additional hoops (such as applying for an employer tax ID number using Form SS-4). But, for those of you who want to fund IRAs for your younger children, the hassle might be worth the benefits. Note: You can download all of these forms, schedules, and instructions from the IRS website.

We don't have the time or space to cover all of the issues you'll face. But, IRS Publication 926, which deals with household employees, does point out all of the requirements and details. So, before you try this little tax gambit, make sure you are thoroughly familiar with the requirements as set forth in Publication 926.

The bottom line (and what makes this entire plan come together) is that the payments made to kids under age 18 for household jobs will constitute earned income for the child, but the payments won't be considered earnings for Social Security, Medicare, or Federal Unemployment Tax purposes. So, you'll be able to pay the kids without the associated expense (both for employer and employee) of these federal payroll taxes. Assuming the child has no other income, the pay given could be as much as his or her standard deduction ($4,400 for tax year 2000) before there is any income tax consequence to the child. Sweet.

Of course, if your kids are already working for others (mowing lawns, baby-sitting, pet sitting, washing cars, etc.), they already have earned income... even if the "employer" doesn't issue a W-2 form to your child. Based on the rules and regulations, this type of income doesn't appear to be considered self-employment income, nor will it be subject to the dreaded self-employment tax. This is true, I believe, despite the confusing language used in IRS Publication 4 (Student's Guide to Federal Income Tax). So, your kids might be able to generate earned income from sources other than you... their parents. All the better.

You'll also read in Publication 926 that there appears to be a $1,200 limit for payment to household employees before Social Security taxes kick in. This is somewhat confusing. Just understand that this $1,200 limit applies to people who are over age 18 and are not considered students. So, don't let this throw you off base.

The $1,000 Car Wash?

Now, before you go out and pay little Susie $1,000 for washing the family car, understand that the services are required to be rendered to you, and you are required to pay a reasonable compensation for those services. So, $1,000 for a good car wash and hand wax might be a bit excessive.

Additionally, I don't believe that the standard "allowance" that a child receives on a weekly basis (primarily just for being cute) would necessarily qualify under these rules. Instead, you would want to make payments -- reasonable payments -- for specific services rendered by the kids. These might be "special" duties covered outside of their normal weekly chores.

Not only that, please don't think that you'll get a "deduction" for the wages you pay little Johnny. Since the payments are for household services, and not business expenses, you won't receive any deduction for having Johnny weed the garden. So, don't get any crazy ideas.

Do the Paperwork

To make this all work for you as a parent, you really have to follow the paperwork and reporting rules... at least in my opinion. I know there are other financial "gurus" out there who will tell you that you aren't required to complete Schedule H and attach it to your tax return for your kid's employment, that you aren't required to issue W-2 forms to the kids, and that the kids don't have to file tax returns. I'm not sure that I agree with these positions.

I recommend, if you're contemplating hiring your kids, that you complete Schedule H and issue the appropriate W-2 forms to the kids. If the kids are working for other neighbors, those neighbors might not issue W-2 forms, so you'll want to make sure that you keep records for the kids detailing the days worked, the services provided, the payment received, etc. This could be done on a legal pad or small spiral-bound notebook that then gets filed with all your other tax records.

As far as having your child file a tax return, that's a more complicated issue. The W-2 forms you issue to the kids will confirm earned income. So, if the W-2 form is enough to cover the IRA contribution (maximum $2,000 contribution per year, per child), and there is no other reason to file (no other income or withholding), then it's likely that you wouldn't have to file a return for the children. However, I generally recommend the "better-safe-than-sorry" method of tax planning -- file the return for the kids, even if filing a return is not technically required.

All of this being said, please remember that this technique is considered by some to be very aggressive. Your tax pro might not concur with my views regarding paying the kids for work performed around the house. You'll have to work that out with him or her, weighing the hassle factor involved in setting the entire process up. You'll also have to do some reading and studying (IRS Publication 926 is the minimum required reading).

After that, you'll have to find an IRA custodian that will accept a "custodial" IRA for the kids (I hear that many brokers will still not open an IRA account for minor children... as silly as that sounds).

Finally, you'll want to follow the letter of the law on this issue, since the IRS might feel the need to question your motives. But, I believe that if you follow the correct steps, don't cut any corners, and are reasonable with the job assignments and payments for those jobs, this entire process should work out quite well for you.

The Payoff

What's in this for you? What is the pot at the end of the rainbow for all of this hassle? A Roth IRA for your child. Why a Roth IRA as opposed to a traditional IRA? Think about it for a second. Your kids will receive no tax benefits for a Roth IRA contribution. But, since their income is below the standard deduction, they'll have no income tax to deal with anyway. So, who needs the tax benefits of a traditional IRA contribution (not to mention the tax liability down the road when the money is distributed)?

In effect, the Roth IRA contribution is a "gimme." The kids will be able to put away money now that (if all of the rules are followed) will be tax-free in the future. Remember: both the original contributions and the earnings will be tax-free. Even if the child is under age 13, there will be no "kiddie tax" issues since all of the income here is earned income (the kiddie tax only impacts unearned income such as interest, dividends, and capital gains).

It will only take a few seconds for you to realize how powerful this can be for your child's investing and financial future. But, only you can determine if it's worth the hassle of the associated requirements and additional paperwork. It sure seems so to a Fool like me.
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