Planning for retirement income is typically the last thing on a teenager’s mind—earnings from summer jobs are usually earmarked for extra spending money or education savings. Despite this, the benefits of opening an IRA or Roth IRA for a minor child can be substantial—and there’s no need to wait until the child has finished his or her education.
Although IRA planning for children is often overlooked, it can provide adult clients with a way to maximize tax-preferred savings for the entire family while simultaneously paving the way to a secure financial future for the minor child. Once the decision to contribute has been made, the important question of which type of account is best—traditional or Roth—must be answered, and the consequences of using each can be significant.
Minors and Retirement Accounts: The Rules
Many clients overlook retirement account planning for minor children because they believe there are age limits that prohibit contributions for minors—in fact, until an individual reaches age 70 ½, the only requirement for funding an IRA is that the individual have earned income for the year. In 2016, an individual may contribute the lesser of (1) his or her earned income for the year or (2) $5,500.
Therefore, if a minor child has a summer or part-time job that generates earned income, he or she is eligible to open and contribute to a traditional or Roth IRA. Generally, a custodial account can be opened with the parent acting as custodian and the child as the account holder—once the funds are transferred into the child’s account, the transfer is irrevocable (i.e., the funds cannot later be transferred into an account for another individual). Once the child is no longer a minor, the funds become his or hers to control.
As long as the child has earned income, it doesn’t matter where the funds that are actually contributed to the account come from—meaning that if the child earns $3,000 in 2016, a parent can fund an IRA or Roth IRA for that child with $3,000 of the parent’s own money in 2016, allowing the child to keep his or her income.
For self-employed clients, hiring the minor child to work in the family business can produce an additional tax benefit because the parent-employers can deduct the child’s earnings as business expenses. However, if the business is organized as a corporation, the child’s wages will be subject to FICA and FUTA withholding even if the child is under age 18 (for sole proprietorships, husband-wife partnerships and certain LLCs taxed as proprietorships or husband-wife partnerships, the wages of the minor will be exempt from FICA and FUTA).
Roth or Traditional IRA?
For most adult clients, determining whether to use a traditional or Roth IRA centers upon potential tax benefits and diversification goals (using a Roth generates a tax-free income “bucket” that can be accessed penalty-free after age 59 ½).
For a minor child, the important considerations may be slightly different.
Because a minor child is unlikely to have substantial income from part-time employment that will exceed the already applicable standard deduction amount, contributions to a traditional IRA will generally not create the current tax savings that are important to adults.
While an adult can lower his or her taxable income by contributing to a traditional account, the child will not realize the same benefit unless his or her taxable income is relatively substantial.