You don’t often think of a retirement account for your children, but the Roth IRA is too appealing to pass up. Once you get money into a Roth IRA, it grows tax-free forever, which is a very long time for a young child!
Tips covered in this episode include:
How Young?: You can start this anytime that your child can independently do tasks that you’re willing to pay her for. You can open up a Roth IRA for any age child and contribute any amount (yes, as little as a $1!)
Earned Income: Your child has to have earned income to contribute to a Roth IRA. That income can come as a household employee which has a lot more relaxed rules from the IRS. All those chores that you already give your child can count.
Keep Records: The IRS can be a stickler for records, so make sure that you keep track. Record when the job was done, how long it took and how much you paid. File that spreadsheet along with your regular tax information each year.
Contributions: Do you think your child will contribute the money that you gave him to his own IRA or spend it on candy? The parent actually wears two hats: the employer gives money to the child (who is going to spend it!) and the parent gifts money to the child who puts it into his Roth IRA (of course, you can transfer it directly).
Other topics include:
- What it takes to actually open the Roth IRA (custodial account)
- What investments to choose in the Roth IRA
- Benefits beyond contributions – such as your child learning about money, investing, working, etc
- Tax implications (none if your child makes less than $1,100 from all sources)
So why would we do this? On today's show, I have a super special guest. I'm excited to welcome Megan Russell from Marotta on Money, Marotta Wealth Management. She is the chief operating officer for Marotta wealth management. She has been working in finance her whole career and has written over 700 financial articles.
Megan, welcome to the show.Megan: [:Mike: [:
Super great. I'll mention that at the top, that I'm super fan of having you here and I'll mention it again later on at the end, where to find you where to find all those great articles.Megan: [:Mike: [:
I am such a massive fan. Of the Roth IRA for tax-free forever. It's a fantastic tool. And so we've definitely talked about that and the trade offs of Roth IRA, and we talked about backdoor Roth and all those kinds of things, but we haven't talked too much about using a Roth for a child or for a minor and how that works and why we'd even want to do that.
So before we dive into the specifics, Megan, why would we consider using a Roth IRA for such a young child?Megan: [:
And then on top of that, there's a whole list of exceptions where you can take out money again, early tax-free with no penalty. So it really just the benefits just stack on top of one another.Mike: [:Megan: [:
So a lot of people listen to you might be like my kid doesn't have earned income, so I guess they can't contribute. But a lot of parents don't realize that household employment can count as earned income for that purpose. So examples of household employment are babysitters caretakers, cups, housekeepers maids, nannies, private nurses, yard workers, those kinds of domestic support jobs.
And it also overlaps with a lot of the things that parents don't want to do and would love to hire their kids to do it actually is pretty convenient to get your kids earned income.Mike: [:
to contribute to the Roth IRA. And That's the same for the kids, that they have to have earned income to be able to do that. And you just rattled off a whole bunch of opportunities for earned income. So we're not, I'd always thought about it as, Oh, this will be great.
When my kids like 13 or 14, so my oldest child is almost that age. And of course he's not going to get a job silly until way later, but assuming he did get a job, you know that at 14, I was like, Oh, that's when I could start doing this. But you're saying you could start much earlier than that, right?Megan: [:
You probably want them to fund their Roth. It's a great way to save money . And then they can get the value of real work and learn what it's like to labor for the things that you earn and own.Mike: [:
The earned income piece. Cause you've mentioned you can get kids working for stuff. So does this have to be like a can we give them any amount of money or any kind of wage? Does it have to be relative to what they're doing? What are the parameters around the earned income?
Especially for youngerMegan: [:
So there's a couple of different guidelines and benchmarks that you can use in my own family. We've been using the there's like a youth minimum wage rate that's within the first 20 days of employment. There it's $4 and twenty-five cents right now per hour. And that youth wage rate is a good benchmark for really young kids, because the idea is they're not super great at what they're doing.
They need a lot of training. And it requires a lot of, employer involvement at the start. And as they gained skills, they can start to command a higher wage. So , we used that as our mental benchmark, but we actually paid by the task. So it takes her a lot of time to do it, but then we figure out what is her hourly wage based on what we're paying her.
And we try to make sure that we're hitting right around that $4.25. Mark. So we're right now, she's at $3 an hour is what her effective wages, but we actually pay her basically a quarter for the jobs that she's doing. My daughter is four and a half just to give some context here.Mike: [:Megan: [:
If I remember right. So that's her favorite one. She likes that one a lot. She'll do that one. Basically every time we ask but then some other ones are watering the plants, so she waters the plants twice a week and she unloads the dishwasher. She'll do the utensils and the glasses and then she also sorts our laundry.
Puts it in the different piles for whose clothes it is or what kind of, here's the cleaning glass. She thinks it's super funny to put it in the no one owns it pile. . So those are all things that she can do independently too. So we can be like, Hey, can you do this? And she'll just be like, Oh, I'm run off and do it.Mike: [:
that's fantastic. But they do a bunch of work around the house and we have chore lists, and so every week they have to, every day they check in and get their chores done, and then I pay them a weekly allowance. So as you were talking about how your paying you mentioned like the per hour. You can use that as a guideline.
And then you said per task, you could do that. I pay kind of like on a weekly, , I guess you could sort of like a salary. Would that still qualify as earned income?Megan: [:
So each time your title does a job, the best advice I have to offer is that you should record when and for how long your child worked. So the hard thing with the salary is sometimes you might lose track of that, like how long they're actually working, but that is in court cases, a super big protection point.
No wait, like they, they cleaned the toilet for this many hours, and then what tasks they were doing, how much they were paid. When you paid them, , especially if there's a difference between those two and how much of that pay was in cash. So those are the five super essential things.
And this list is made from the guidelines in IRS publication, 926, which is a household employer's tax guide. It's also compiled from some of the best guidance I can lift from tax court cases of places where people lost, what was the thing that made them lose. So that's how I've compiled this list.
I don't think it's too strong to say that if you hire your child, you need to have this record. So it's really important if you don't want to reinvent the wheel. I have on my website, a form I made, which we use in my own house that just has. A box for you to write each number. So you don't have to remember what do I need to record?
I just made the form and I put it online. You don't have to reinvent the wheel, but the salary does work. It's just that sticking point of like how long the child worked that might get in trouble.
There's a tax court case where the parents were hiring their kids to clean for their daycare. , it was an in-home daycare and they were cleaning all of the bathrooms and things for the daycare and they were paying paid on a salary basis. And because they didn't have. How long the child worked at cleaning the IRS tried to make the claim that, Oh They were cleaning the toilets at times when you weren't paying them for it.
And then they were also so cleaning the toilets at times when you were paying them for it. And that shows that they weren't really working for your daycare. So there's an extra level here. That's like they were getting a business deduction for the wages, which is of course the IRS cares way more about that than they do about just earned income.
But at the same time that how long. Their kid worked is actually pretty important to the IRS as evidence that you're keeping track of the employment side of things.Mike: [:
I need to also write down how much time that they're spending throughout the week. Like when they're doing those tasks. It's important to keep that documentation.Megan: [:
It's just that the best practice would probably say that having that record will protect you more. And if it's easy to get and you know what it is, you may as well just put it on the form.Mike: [:
Now, again, before we get into the details When we're talking about amounts of money, I mentioned all my kids are in the tweener years, they like to call it. And so they're getting about $5 a week for this list of chores. They have to work on daily. What's the starting point.
I Your, you said your daughter's four and a half. I know you started when she was , even younger than that. How much money is she making and how much are you putting into a Roth IRA?Megan: [:
So we're talking really small amounts. I think they're so small that. I've had people mock me for saying wow, that's a lot of paperwork for a $1.70, but I think those same people will be surprised at the princely sum that it can turn into. Because when you think about how long of a time horizon she has to invest, we're talking, she's four and a half.
We're talking, she's got 60 years to let those funds just sit and grow. And so even at an 8% annual return, which is pretty low, given that huge timeframe. But even at an 8% annual return, you can estimate the growth by just removing the decimal point. So $12 remove the decimal point. We've got two more zeros sitting on the end there we've got 1,200.
So in this way it's not too hard to imagine from very small diligence savings, maybe larger than I have, but very small diligence savings. It's not hard to imagine making your child a million.Mike: [:
Is going to turn into $1,200, for her, I think she'll be pretty happy having, some extra money in her account. I guess I was going to also ask, cause it does seem very small. Okay. A buck 70, for a quarter. And
so going through the opening, the accounts though, I can see a lot of people rolling their eyes and say, Geez I, there's no way I'm going through that for a dollar.
But what other. Benefits besides the compounding, do you see in working with your daughter, right.
I'm sure there's other benefits of teaching . points and everything around us.Megan: [:
Of, you've got the parent child, you've got teachers student now we also have employer and employee. And so she's getting into practice all of those relationships and probably the safest context that she possibly can. If she treated her. Her first employer in the future, the way that she treats me she'd get fired, but at the same time, , because we get to have that practice, she's getting to learn how to interact act was an employer in a healthy way and how to do a job cheerfully and how to do a job, even when you don't want to, because the pay that you get and how to choose, even when you need to do a job that you don't want to do.
And when you don't need to do a job that you don't want to do. And so , she's getting so many lessons there. And then on top of that, having money in her pocket, which is hers, What she gets to decide what happens with it. I think that's the only way that you can learn saving and spending. , you can model it with your example as a parent, but at the end of the day, if they don't have money that they make choices with, they're not going to learn how to do the right thing with it.Mike: [:
And the kids of course were running around. Can I have this, can I have this? Can I have this? And it was driving me absolutely nuts. And so I gave them some money. Okay. You have $10 or whatever it is, and now you can decide what you're going to spend it on. And so now sudden there, you could see it.
shifting in their mind like, Oh well, you know, if I only have $10 now I have a limited resource, not the parent That's has a limitless wallet. And so, the wheels started turning and thinking, Oh how am I going to spend my money? And it completely changed the context. Of course, then the conversation was no longer can I have this? It's. How much is this, how much is this? How much is this? Cause they couldn't read all the labels or didn't know in the market, how much everything costsMegan: [:Mike: [:
But you're exactly right, , and that's the one teaching thing that, that we've been fairly successful, having their own money in their own wallet, completely changes, how they view. Goods, that they want, of course they want everything just like every other human being.Megan: [:Mike: [:
Very good point there. I love that. And I love all your comments around having the job and really interacted, especially with the employer and stuff. It's great. You know what a great context kids don't grow up, right? There's suddenly are just there's so much around finances. They're not taught. We all know that, but even just that employer, employee relationship.
All right. Super cool. Megan, I've got questions now on how we're actually going to do this. We understand Roth IRA, many people interact with this, or just traditional IRAs, individual retirement accounts. You can have that first job. You suddenly realize that there's such thing as a 401k, cause your employer might be putting some money in for you.
That's fantastic. And so you say, Oh, I could do this on my own too. How do parents get started with their minor child around IRAs?Megan: [:
So the child is the account holder. They're the one who actually owns the assets, but there's the second relationship, which is they call the custodian, which is the adult on the account. It can be anyone it's normally a parent. And then there's another concept. That's the age of termination.
And so that is the age at which the account. Becomes fully, just a normal Roth IRA that the child owns and that parent custodian relationship gets removed from the account. You get to pick the age of termination on most of the forms you get to pick up state's maximum. So it's a state by state law. I have a link to where you can find a list of all of the States age of termination maximum.
I recommend that you just pick the maximum and that's not because I think that the asset should be locked up until that point. It's because at any point you can decide to. Terminate that earlier and roll it over into a Roth, but you can't like clot back after the fact. So you may as well just pick your state's maximum.
And then if it turns out that like you picked 21 and an 18, you really just want them to have it themselves. Just make it happen. . So those are the big things for filling out the forms, the account holder, the custodian and the age of termination.Mike: [:Megan: [:
But when you're setting up an account, any kind of an account for a kid, you have to tell the custodian who specifically is going to custody the assets. And so that's confusing because there's two custodians. Charles Schwab is also called the custodian because they also custody the assets. But anyways,Mike: [:Megan: [:Mike: [:Megan: [:
And that's the parent relationship , that's just what we think of when we think of parents. But then there's a second relationship that parents also carry, which is the custody of the assets. And that's, who's responsible for taking care of the stuff your kid owns.
And when you open an account like a custodial Roth IRA, you need to pick one person to be the person who custodys those assets. So by default, it's normally A husband and a wife are both the parents and either of them could be the custodian, but when you open an account, Charles Schwab would want to know which one are you, is it who's the person who's going to be responsible for this.
And that's because the custodian on that account is held to the fiduciary standard. And so you're required legally to act in the best interest of the person who really owns the assets, which is your child. And they want to know if something goes wrong with this account, who do I put handcuffs on?Mike: [:Megan: [:
the parent. Exactly.Mike: [:Megan: [:Mike: [:
thing with the assets and investing them appropriately , managing that account for the child until they come of age. So , you pick one parent to be doing that. Now, could this also be a grandparent, could a grandparent do this for a child?Megan: [:Mike: [:
Now, while we're on the subject of some specifics, , so now we have the account open and putting money in there.
How are we going to transfer like a dollar 70 or, you know, do we have to do it every week? We do it like once a month or at the end of the year. How does that kind of work?Megan: [:
Cause rather than reinvesting it, I'm just gonna use that to fund the Roth. So you can do those online transfers really easy if you just open it at the same place where you have everything else and you can contribute to Roth in exactly the normal timeframe as anybody contributes to a Roth, your kid is
A minor, it's taboo to think about them as a whole person sometimes, but they're a whole person, they get the same set of rules that everybody else gets. It's just that they're not allowed to be the person directing the assets at the actual bank.Mike: [:Megan: [:
And the contribution to her Roth is not the money that she earned. It's me as her parent saying it's smart tax planning for her to fund her Roth. So if we think about it, super nitty gritty, the way the IRS would think about it. I have hired her and paid her a physical quarter. And that was the employer hat that I was wearing.
The parent hat that I'm wearing. I also gifted her a quarter, which I put in her Roth IRA. So just in case it ever becomes relevant to somebody like you're paying your child huge amounts of money, and you're going to be contributing huge amounts of money. You just have to think about the it's a gift it's paying that the child.
And how it's all going down. So if you don't want to double the money that you're actually giving your child, you may want to pay them directly to their RothMike: [:
So , let me say that one more time. So , let's just say it's a hundred dollars for a year. , I would give my son, a hundred dollars, and that if I want to do this the way you're doing it, I would also put a hundred dollars into the Roth IRA.
So now out of my pockets, $200. So $200 out of my pocket, one, he got to keep, he had earned income of a hundred. That's why I could put the other hundred. Into the rasa. So in the IRS rules, it is like his hundred going in there. Like I gave it to him that the second hundred and he contributed it,Megan: [:Mike: [:
Into his , custodial Roth IRA.Megan: [:
I, as your parent am going to gift you a dollar old Saturday or Roth. So you can set up scenarios, which are more real-world scenarios about. Retirement savings to teach those lessons again. And also you can get , their grandparents, and on this. So grandparents love giving money to their kids.
They love teaching them about finance. And so you can get the grandparents and saying, Hey, actually like your parents gonna match you a dollar, but I'm gonna match you a dollar to, you can really incentivize it for them. And if they choose not to do it they'll learn. I think quickly how much money they're leaving on the table.Mike: [:
That you can give to any single person, including your own child with no tax implications or having to file anything specific. But in terms of tax filing, if we're doing, a dollar 70 or we're doing a hundred dollars is there anything we need to keep track of to actually file when it comes to tax filing time?Megan: [:Mike: [:Megan: [:
If all of it is earned income, then the standard deduction is really the benchmark for whether or not you need to file.Mike: [:Megan: [:Mike: [:
Oh, is there a limit? To how much your child could put into a Roth IRA. I know we have the earned income. So if they only make $100, you can only put a hundred dollars. But there is it the standard limit for everybody in terms of contributions.Megan: [:Mike: [:
Pretty easily as a teenager. Good to keep track of there. And that's where I would definitely get the grandparents involved.
If you want to start doing those kinds attributions.Megan: [:Mike: [:Megan: [:
So a traditional IRA. Not a great idea there, unless your parent to the Olsen twins who are independently millionaires, , it's just not a good move,Mike: [:Megan: [:Mike: [:
Is it bizarre to be talking about retirement accounts?Megan: [:
I'd love for her to have such an easy life that this money makes it all the way to retirement. But I think about it more as just helping her solve problems that money can solve in the future. And so maybe this is going to be okay. Buying a house, maybe this is going to be starting a business.
Maybe this is going to be helping her pay for medical bills. Maybe this is, I don't know what it's going to be, but there's so many emergency fund type situations that also qualify as exemptions for the penalty that. Really this money could be used for almost anything, especially when you consider that you can withdraw what you've contributed.
I really see it more as just a tool for early financial freedom. Maybe she could take a year off because she has Roth money. I have no idea what it is. It's going to be but setting my expectation there, I think both prepares me well for if the day does come, that she wants to withdraw from it.
I'm not going to be like, but that was your retirement. And I'm going to be sad about it. Instead, I'm going to be super happy. I'm going to be like, I saved money that is solving a problem that money can solve. And there's so many problems, money can't solve that. I'd love to empower her to solve the ones that it can.Mike: [:
That's what that account is. But no. There's a lot of ways that you can take money back out of the Roth. IRA, all your contributions. After the accounts been open for five years can all come out, tax-free penalty free. And then as you said, there's also a number of exceptions. To the rules that you can take money back out of this account.
The Roth IRA is a fantastic savings vehicle in general. It's one of the top accounts that you should be funding because of these specific rules. Now, that being said, I will play the other side too. You want to be careful taking money out of your Roth
IRA, because once it's out of there, you can't get it back in.
It's, there are limits to how much you can.
put in every year. so be very careful before you withdraw money. For some reason, see if there's some other source. That you might be able to even, I would say even if you had to take some kind of different loan, not a credit cards with high interest, but there are other ways of getting low interest loans that you might want to look into that even if you're paying interest to remember that money is growing tax-free ever and forever is a long time.Megan: [:Mike: [:
Is there anything else , that we should consider that we haven't talked about?Megan: [:
That's how people paying their kids. Not realizing that it's earned income are not doing tax evasion was because they have that exception written in. But after your kid becomes of age, those payroll taxes come back, there might also be state payroll taxes that get added in. So you need to look up your specific state.
So that situation gets more complicated when they're 18 or 21. There's different things that roll in. Other than that, there's not that many special considerations. Minimum wage laws. For example, don't apply to parents who are employing their minor children. So you don't have to worry about that people of every age benefit from a Roth.
So it's not like they age out of it. It's always a good idea. Also unlike an UGMA , which is like a custodial brokerage account that a lot of parents save money. And unlike that the Roth is tax free, so it's gains interest dividends. They're not going to affect your kids tax planning. It's not going to suddenly become a problem on their tax return.
And unlike a 529 plan a Roth IRA doesn't count towards the FAFSA. Retirement accounts owned by either you or your child, neither of them are counted on that expected family contribution. And so it's not going to mess up them getting financial aid.Mike: [:
That is great. Okay. And I loved your other comment, just snuck in there about there's no minimum wage rules when your, to your parent and your child.
That's fantastic. Perfect. Okay. Now the one thing we haven't talked about too much, so we got the IRA we're going to contribute to it. We've got the earned income limits or whatever you give to them. You could double that and get it in there, get them going. We have compound interest for decades, which is fantastic or compounding.
For decades, what do you recommend on the investment side? Within the Roth IRA? So we've got maybe a buck 70 in there. Maybe you've got a hundred dollars in there. What can we do to get that invested in what would be a recommendation for those investments?Megan: [:
Because of that, you can't really get a dollar 70 invested. So with a mutual fund, you'll be able to get that fractional share of the mutual fund and keep really small sums, fully invested. So mutual funds. The second would be that. A lot of mutual funds still have a transaction fee. So major custodians a lot of them have moved to no transaction fee ETFs, but most mutual funds still carry a pretty hefty transaction fee compared to zero obvious place.
30, 40, $50. If you're investing a dollar 70, that's going to get eaten up real fast to avoid that fee. You should browse the custodian specific list of no transaction fee mutual funds. So each custodian will publish a different list. Normally it has their own funds on it. So at Schwab, the Schwab funds are on the list at Vanguard.
The Vanguard funds are on the list, so on and so forth. But shop that list so that you don't have all of the savings go to the bank. The third would be that you want to get very volatile investments with a high expected return. You want ones that trend upward. So I'm not talking about penny stocks here, but .
Things that you might invest in. Look at the ones that have the higher expected return and the higher standard deviation, because they're really great for investors with a long time horizon and no withdrawal needs, which accurately describes a child. So examples of that would be emerging markets, small cap value, mid cap value, large cap.
Those are the ones that I was looking for when I was looking for my daughter's account.
, fourth, you'd also want to focus on getting low expense ratio funds. That's true for everybody. That's also true for kids. A lower expense ratio means more of the returns are kept for you, the investor and less of it goes to that fund company.
So my advice is to focus on funds where the expense ratio percentage begins. Point zero. So 0.04%. Just look for those ones. If you have to go a little bit higher than that to get just the funny one. Okay, fine. But focus on the ones that have that 0.0.Mike: [:
You should be able to find the funds for sure. 0.0 X percent should definitely be available there. Okay. Fantastic. Megan, is there anything on this, the Roth IRA's for minors that we have not covered?Megan: [:
That gives you the, a lot of options in there. Employing them in a business. You can get the business deduction , so that's awesome. If they meet the requirements, they can participate in your 401k, which is also pretty cool. And then they can contribute to Roth. So a child earning $500 in a family business, they can defer it to their Roth, 401k.
Hopefully if you have a Roth option there, they can receive the employer match. They can get profit sharing, and then they can also contribute to their Roth IRA. The IRS is more likely to challenge children employed by parents and small businesses because of that business deduction. So you need to make sure your records are super clear.
You've documented everything. You do everything in the cleanest way possible. You treat them just like other employees. And if they're really young, like so young that the IRS might question that they're capable of doing what you're doing. I personally would also film them one time doing it, just to prove.
Look, hands-off, they're doing the job. That way you can have all of that with your records in case they come to say, really can your six-year-old alphabetize. You can be like, look at her right there. She's doing it all by herself. . So that's a another really great option that's out there.
And there's a whole page on the IRS called family help, which teaches you when you're employing them in the business. What are all the exceptions that you can have? And there are a lot of, yeah,Mike: [:
You get the kids involved in the family business, and you can shelter a lot of money. Now, of course, specifics, just do what's in the rules and keep track of that. As you said, I love the tip on the video taping. But have your , children, employees, just like every other employee, but there's a lot.
That you can do when you really want to strategize around tax shelter and transferring wealth around owning your own business. So really good tips there. Megan, , Megan, how can people find more on these topics?Megan: [:
I firmly believe that if somebody had enough time to read all of those articles and had enough time to implement all of those things, they could do what we do for themselves. , we strive to empower people that way. You can find us online at marottaonmoney.com. That's M a R O T T A on money.com.
And from there you can subscribe to our weekly newsletter. So we just email out what are the latest articles that we've written and you can follow along and craft your own financial plan.Mike: [:
Trust me, there are so many great articles how to run your own portfolios. What portfolios are, , the ins and outs of every one of these different accounts and everything. So highly recommend checking out the website, the blogs, everything that they do and subscribe to the newsletter. Megan, thank you so much for coming on today and letting us know all about this.
Great. Roth IRA tool for minors. I think it's going to be fantastic for folks and especially getting the word out around this because it's a great tool that the IRS lets us use and we should take advantage of it. So thank you very much for being on the show today.
Thanks so much for having me.
Thanks for joining us on financial planning for entrepreneurs. If you like, what you heard, please subscribe to and rate the podcast on Apple iTunes, Google play Spotify, or wherever you get your podcasts. You can connect with me on linkedin or mortonfinancialadvice.com. I'd love to get your feedback. If you have a comment or question, please email me at firstname.lastname@example.org. Until next time thanks for tuning in