Updated: Oct 4, 2021
This summer, our family celebrates the 13th birthday of my niece. She’s growing up, and her flower is full of spring. And at 13, she still views her uncle as “cool,” which is refreshing. Young people share a few things in common. One is the gift of time. Another is the opportunity to learn tools that will benefit them through their lifetime, particularly from their trusted village.
The discussion of money conversations and concepts early on, kitchen table talks, if you will, helps increase life and money well-being later in life. This year with her present moment fun gifts, we included a gift that grows—one which she appreciates now and will learn to value more later. We continue to have conversations about cash management concepts such as saving and spending plans. Now we have the opportunity to discuss investments planning.
Roth Individual Retirement Account (IRA) for Minors
Individual Retirement Accounts (IRAs) are tax-advantaged investment accounts that allow investments to grow across time without paying annual tax on the growth. These accounts provide shelter for investment returns to compound on higher amounts of principal. Given more time, the “money magic” of compounding becomes more powerful. This time factor is more advantageous to children, teens, & young adults.
There are two types of IRAs; traditional and Roth. Traditional IRA allows for tax-deductible contributions, tax-deferred investment growth, and taxable distribution depending on earned income thresholds. Roth IRAs allow for after-tax contributions, tax-deferred growth, and non-taxable distributions. Roth IRAs are attractive to younger individuals because due to lower earnings, they are more likely to be in a lower marginal tax bracket now compared to later years in life, which makes the tax-deductibility of Traditional IRAs less attractive, and the tax-free distribution of Roth IRAs more attractive.
To be eligible to contribute to a Roth IRA, you must have earned income and consider income thresholds. Furthermore, there are annual contribution limits to Roth IRAs. Income thresholds and contribution limits are adjusted annually by federal tax law. For 2021, a single individual with a yearly income of less than $125,000 can contribute 100% of earned income or $6,000, whichever is less. Those with incomes between $125,000 and less than $140,000 can make a partial contribution.
Roth IRAs align with younger people because they earn less income in their work-life stage, which allows them to contribute to Roth IRA and maximize that contribution.
Your child can earn a W-2 income on their first employer-based job. My first job was part of a work-study program as a junior in high school. Your child can earn an income through age and work-appropriate performance-based jobs before W-2 income eligibility.
Earned income does not include paid allowances or money paid for house chores. There are jobs that your child can perform that have an identifiable market rate. House painting, babysitting, lawn mowing, administrative, and technology-based jobs. In substitute of a W-2, keep track of your child’s income and document each earned event which includes:
Type of service
Customers who received service
My sister is the owner and master creationist of Freely Focused, specializing in fine gifs and photography. The family business provides an excellent opportunity for fun family time and collaboration on customer orders, which offers an opportunity for your child to earn income. Tada! Earned income qualifies your child and others to contribute to a Roth IRA up to the amounts earned, up to the allowable limits.
Federal child labor laws allow parents solely-owned small businesses to hire their children before age 16 with minimal restrictions explicitly defined. State and local child labor laws define their employment certification and hours allowed rules that apply to minors.
Other examples of age-appropriate jobs are to hire your infant as a model for company imagery for firm collateral material or office wall decor, social media maven, digital file expert, or “there’s an app for that” administrative guru.
Eligibility for need-based financial aid for college is complex, and we will cover it in another blog post. How much aid a child receives is determined by the calculation of the Expected Family Contribution (EFC) using the FASFA® form, which considers, among other factors, the income and assets of the parents and the student. Generally, the higher the EFC index number, the lower the need-based aid.
Alas! The good news is that qualified retirement accounts of the parent such as 401(k) and individual retirement plans such as Traditional and Roth IRAs are excluded from the EFC calculation. The same rule applies to your child’s Roth IRA, which keeps the EFC from increasing.
However, distributions from retirement accounts count as income, which increases the EFC and harms financial aid eligibility. Distributions from IRA retirement accounts can be used for qualified education expenses (QEE). While QEE distributions avoid an early withdrawal penalty, depending on the IRA structure, contribution, and earnings allocation, QEEs will generally be taxable and still count as income.
It is generally advisable to avoid early distributions from retirement-based accounts whose objective is to support retirement. These accounts tend to adopt an invest and hold, long-term investment strategy to fund a future retirement lifestyle.
Yes, filing our annual taxes can be pesky, and at times so can our young loved ones; however, their futures are not. As of this writing, your child must file a federal tax return if their earned income exceeds $12,400 or receives unearned income, also referred to as investment income such as dividends, interest, and capital gains, above $1,100.
Portions of your child’s unearned income could be taxable, commonly referred to as the “kiddie tax.” The “kiddie tax” applies to individuals under age 19 (full-time students between ages 19-23).
The first $1,100 qualifies for the child’s standard deduction.
The second $1,100 is taxed at the child’s tax rate, which is generally at or near zero,
Amounts above $2,200 are taxed at the guardian’s marginal tax rate.
Filling a tax return for your child, if they generate earned income, has benefits regardless if required, tends to not be extra burdensome to the parental tax filing process. The benefits include:
Earned income record for IRA contributions
Earlier Social Security earnings record
Could qualify for a tax refund
The “kiddie tax” is generally mitigated with an investment strategy that avoids active trades, which could trigger large capital gains.
Long-term time horizon
Buy and hold
Low or no dividends
How and who can fund
Once your child (young adult) has generated earned income, they can contribute to the Roth IRA. As their guardian, you must open their custodial Roth IRA. Select popular platforms offer custodial sponsored Roth IRA accounts, such as TD Ameritrade or Fidelity. In the year your child has earned income, they can contribute the lesser of their earned income or the maximum annual contribution limit.
Great news: Your child, family members, and supporters can make contributions to the account.
One of my earliest introductions to money by my parents was a savings “matching” plan. If my sister and I saved a dollar amount of our allowance, our parents matched that dollar amount. Just imagine if that savings account was a Roth IRA with multiple contributors, investment capabilities, and the effect of compounding returns.
Story 1: Assume a child generates earned income of $1,000 each year from age 13 to 20 (7 years). Across the seven years, makes annual contributions of $1,000 to the Roth IRA, which comprise earnings from the child and “matching” gifts from the family members. From age 20 to 63 (43 years), no other contributions or withdrawals are made. Assume a 7% annual return across the 50 years. The account would grow to around $158.750.
Story 2: If $1,000 is contributed every year across the same 50 years, with the same 7% annual return, the future amount is around $406,529.
Story 3: If $6,000 is contributed every year across the same 50 years, with the same 7% annual return, the future amount is around $2,439,174.
Essentially, this is what my nieces and your child’s (young adult) birthday, future holidays, celebration days, or regular occurrence events can be. Gifts that keep giving and growing over a long time. After a while, tangible items can be complemented or substituted with longer-term delayed gratification gifts that make a transformational impact and help young people create their life’s design and pursue their life aspirations with a boundless spirit.
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Life Money Balance™
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