So many life lessons in one Roth IRA
What can a retirement account for your 3-year old do for their overall financial well-being? Hint: it’s more than just saving them money on taxes. The Roth IRA is one of the best accounts1 to grow money tax-free, forever. Compounding interest takes time, so starting early can lead to major pay-outs later in life, to the tune of 100x! In order to apply this benefit to your minor child, they must be employed. No, I am not suggesting you strap a bag of newspapers to your toddler’s tricycle, but employing them to clean up some toys is enough to do the trick.
I had the pleasure of speaking with Megan Russell of Marotta Wealth Management. She is a finance guru and an expert in using Roth IRAs for minor children.
What follows are my notes from the podcast Megan and I did together featuring her expertise in establishing retirement accounts for kids. If you enjoy this topic, consider reading Megan's Custodial Roth Funding series. In addition, I highly recommend that you sign up for the Marotta on Money Newsletter which contains a wealth of actionable information regarding such topics as budgeting, investing, and general finance
- Where to begin: First, your child needs earned income in order to establish a retirement account. Be your child’s first employer.
- Using a Roth IRA means tax-free growth forever. See the difference between 60 years of saving vs. 30 years.
- It’s not just for retirement. Your child can use money in their Roth IRA before the age 59 ½ to pay for medical expenses, disability, higher education and a one-time home purchase.
- Tracking earned income from a young age: keep records!
- How-To’s: Opening an account and investing
The benefits of employing your child from a young age
In order for your child to contribute money into his Roth IRA, he needs to have earned income. Think back to your first job: did you know how to interact with your boss? Were you comfortable asking for instruction? Being your child’s first employer allows them to have a gentler introduction to the workforce and adds an additional layer to your relationship. Teach them valuable skills such as following a job through to completion and what to do with earned income, including budgeting for special trips to the toy shop or ice cream stand.
Personal finance is a life lesson that, unfortunately, is not taught in school (at least not with any depth). Children need the opportunity to learn about making and spending money and the best way to do so is with experience. Interacting with cashiers at shops, basic math functions, introduction to credit lines, and prioritizing expenditures are practical skills not found in a textbook. The earlier you can introduce these topics, the easier it will be to understand the interaction of money, time, and joy.
Having money in her pocket, which is hers, she gets to decide what happens with it.
Employing your young child doesn’t mean forcing hard labor. If she can do small tasks all on her own such as picking up sticks from the yard ($.10/stick), unloading the dishwasher ($.05 for every fork), or sorting laundry ($.25 for paired socks), that counts as earned income. The IRS has defined “a household employee” and you can employ your child to do that work. Following IRS guidelines, you can pay per task or establish a wage. This is earned income for your child.
Why did I assign value to the household tasks above? When it comes to how much you can pay your child, a common-sense rule applies: depending on the age of your child, the task they are working on, and what you might pay another worker to do the same job, you determine a fair wage.
Things to consider as your child gets older
Once your child begins working out of the home, such as after school jobs or summer employment, be aware that there are limits to the Roth IRA contributions. They are no different from adult regulations: the lessor of $6,000 or earned income for the year. In addition, the household employment rules change when your child reaches the age of 18 or 21 (state-dependent).
Another consideration is how this Roth IRA might affect your college application process, the FAFSA, or Expected Family Contribution (EFC). The good news is that retirement accounts (your own and your child’s) are not reported on these forms. This is yet another reason that the Roth IRA is a great way to save for college, beyond the usual 529 account (which is reported on the FAFSA and EFC).
A note about family businesses and employing children
If you have your own business, it is a fantastic idea to employ your child in the business not only for all the benefits outlined above but for the additional perk of taking business deductions. Just make sure that you tread very carefully and follow the rules. The IRS monitors businesses that may be looking to exploit the deductions vs. household employees.
You can employ a child at any age as long as the business is not hazardous (as defined by the IRS). So even a very young child could help file, organize, clean, or perform other duties around the office. Just make sure to check the rules below about record keeping and treat your child just like any other employee.
Getting a business deduction is a great savings tool for the family business while paying your child. They may also be eligible for the 401k plan as well, which would be a great incentive to add a Roth option to your 401k. Megan's blog offers practical advice on hiring your children and you can find more information directly from the IRS Family Help.
Why a Roth IRA?
The short answer is that a Roth IRA keeps more money in your pocket and less in Uncle Sam’s. Sure, you could open checking, savings, or brokerage accounts, but the Roth IRA is the only account in which any money you make is non-taxable, in perpetuity. In the case of a child, that’s a long, long time.
If your child is under the age of ten, money that you contribute to a Roth IRA in their name has the chance to grow 100x! So, contribute $200 in 2021 and that amount could be worth $20,000 when your child decides to retire.
It’s worth the effort to open and fund a Roth IRA for your minor child because of that tax-free compounding growth. If you invest in a brokerage account, each year taxes will slowly eat away at that growth, which adds up over time. Sixty years of compounding will yield significant returns. Think about it in terms of a mortgage: how much would your house cost you if you were to take 60 years to pay it off. Use the compounding to your child’s advantage!
Considering a UGMA or UTMA? These accounts are taxed at a much higher rate. Avoid the added expense by taking advantage of a tax-free Roth IRA instead.
From very small diligence savings, it's not hard to imagine making your child a million.
Does my child have to wait until they retire to use this money?
The Roth IRA is generally considered a retirement account, but there are a number of circumstances in which money can be withdrawn prior to retirement. After the age 59 ½, anyone can withdraw any amount from their Roth IRA, for any reason, tax-free and penalty-free. There are also lesser-known ways to access this money without being penalized.
Some common exceptions for withdrawing money from a Roth IRA include:
- Medical Expenses: If you do not have health insurance or have out-of-pocket medical expenses that aren’t covered by insurance, you can use funds from your Roth IRA. The medical expenses need to be in the same calendar year as your withdrawal and exceed 7.5% of your AGI.
- Health Insurance Premiums: If you are unemployed, you may be able to pay for health insurance premiums using your Roth IRA.
- Permanent Disability: If you are no longer able to work, the IRS will allow you to withdraw Roth IRA money without the penalty
- Higher Education Expenses: The Roth IRA is a great way to save for college. You can use the money to pay for tuition, fees, books, supplies, and other qualified education expenses.
- Home: You can withdraw up to $10,000 (lifetime limit) to buy, build or rebuild a home.
And finally, you can withdraw any of the earnings at any time and choose to pay a 10% penalty. While not encouraged, a 10% penalty isn’t a big deal if you need the money in an emergency.
One final note of caution: Once you withdraw money from your Roth IRA, you cannot put it back into the account (although you can continue to contribute each year). Since this is a tax-free place to save your money, Megan warns “It's definitely the last account you tap.”
You can pay your child by the task, by the hour, or a salary - the choice and the requirement to document are up to you! If the IRS comes knocking for an audit, just like anything tax-related, it’s really important to have documentation to show all of your financial finaglings is on the up-&-up.
Each time that you pay your child, keep a record of the following:
- Task: What did they do?
- Time: How long did it take?
- Amount: How much did you pay and in what form (cash or other)?
Keep this log alongside your other tax-filing documentation each year. Megan recommends using this handy sheet that you can print out and keep with your records.
For more information, the IRS has a handy Household Employers Tax Guide.
Another tip: Videotape your child doing the task on their own. Especially when employing a child in a family business, if there is any question about “can your child really handle this task independently?” it's important to have proof of work completed.
As long as your child makes less than $1,100 from all sources (earned and unearned income), no tax filings need to be submitted. Above that amount, it’s time to look up the rules. Megan Russell points to a very handy guide on her blog: Do Children Need to File a Tax Return?
Where to begin: A How-To Guide
Opening An Account
Let’s start with how to open a Roth IRA account for a child and begin making contributions. All the major brokerage firms (Schwab, Fidelity, Vanguard, etc) have the account that you’re looking for: a Custodial Roth IRA. The “custodial” part is because your child is a minor and therefore needs a custodian (the parent) to be responsible for the account. It’s as easy as logging in, clicking the account, and transferring money.
When you open a new Custodial Roth IRA account for your child, some things to keep in mind:
- Be sure to look for the word “custodial” in the name - that’s the type of account that you want to open for your child.
- The account holder is the child. It’s their money, so they are the account holder.
- Custodian is a parent. You are responsible for managing and investing the account on behalf of your minor child.
- Age of Termination: This is the age at which your child will begin managing their own account. This requirement varies state by state. Megan recommends that you pick the highest age possible, you can always turn the account over earlier if the need arises, but you cannot increase the age later.
Once the Custodial Roth IRA account is open, contribute money from your checking, savings, or brokerage account in the same way you normally transfer funds. Remember that you are limited by the lesser of your child’s earned income or $6,000 (for 2021).
You want to invest the cash that you just contributed to the Roth IRA so that it will grow and compound over the years. Here are four tips for investment:
- Use Mutual Funds: In general, Exchange Traded Funds (ETFs) are ideal, but if you are investing small amounts of money for a very young child, most brokerages don’t allow you to buy fractional shares. You’ll have to save over $3,000 to grab that first share of AMZN. Start with Mutual Funds since they allow for smaller investments.
- No Transaction Fee (NTF) Funds: If you are investing a small amount to start, you certainly don’t want your money to go toward fees. Many mutual funds have fees to purchase the shares, which could really take a bite out of your investment. Therefore, look for an NTF fund at your brokerage to get your entire sum invested.
- Volatile investments like Emerging Markets or Small-Cap Value: You hope that your child will let this money stay invested for many, many years and therefore you want to pick an investment that has a high expected return. These funds are the same ones that can bounce up and down wildly, or have high volatility.
- Low expense ratio funds: Mutual funds and ETFs have ongoing expenses to operate the fund. These fees have dropped significantly in recent years, so you should be able to find an appropriate fund with an expense ratio that starts with 0.0 % (e.g. 0.07%). You don’t want your compounding gains paying down fees.
You want to invest in very volatile investments with a high expected return
Take the opportunity to employ your kid around the house and teach him or her necessary skills early in life. Start a Custodial Roth IRA to set them up for future financial success. A big thank you to Megan Russell for coming on to the show and sharing her wonderful knowledge on this topic.
1 The HSA is one of the best accounts given it has triple-tax benefits.