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Compound interest is amazing. When our money starts making money over and over again, that’s when our retirement portfolios can grow rapidly. A funded Roth IRA will have a 6-figure sum in what seems like no time at all.
But what if we could harness that same power for our kids and turn them into future millionaires?
Today, I’ve invited Logan Allec to talk about how we can do this with a Roth IRA for kids. Logan is a CPA, real estate investor, and a full-time personal finance blogger.
And after spending nearly 10 years helping big businesses save money in his role as a tax advisor, he launched his site Money Done Right to help everybody make more money, save more money, and grow more money.
Andy Hill: What is a Roth IRA?
Logan Allec: Well, a Roth IRA is an investment account that the government basically gives you tax benefits for. You put money into a Roth IRA. You don’t get a tax deduction this year, but you know the money in that Roth IRA if it’s invested, grows over time.
That growth is tax-free.
And once you start taking it out after age 59 1/2, you can take out those distributions tax-free, as well. So, it really is truly tax-free growth if you can keep that money in the account for the next few decades.
How can we use the Roth IRA to help our kids become millionaires?
For adults, you often have to make this decision between contributing to a Traditional IRA versus a Roth IRA. Because with the Traditional IRA you get the tax benefit now.
Your child, who probably isn’t making a whole lot of money, and he probably won’t pay any income tax so he doesn’t really need that tax break now. So the Roth IRA is in many circumstances a no brainer.
And when we say the Roth IRA can make your kid a millionaire, there are some assumptions based on future growth rates and all that, but they’re nothing crazy.
Let’s say you start paying your kid $15 or $20 to help you in your business, starting at age 9 or 10. That’s about $900 bucks a year.
And let’s say that amount increases by $100 a year all the way through age 18. And let’s say they can contribute all those earnings into their Roth IRA.
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Well, if you do the math and you assume an 8% rate of return until they’re age 70, they’re going to end up with a Roth IRA with over a $1,000,000 by the time they’re 70.
Granted, $1,000,000 60 years from now might not be what $1,000,000 is today, but still, you know, that’s the math.
What if our kids continued investing after they turned 18?
Oh yeah. I mean, they would be multi, multi, multi-millionaires if they kept that habit up throughout their lives.
So you know, this is truly making your child a millionaire. Maybe not now, but in the future just for pushing them along this path while they’re still living under your roof.
What are some investing rules for a Roth IRA for kids?
Well, the number one rule to keep in mind is that the child must have earned income, and they can only contribute to their Roth IRA up to that earned income amount.
So if you’re paying your child, you have to pay them a reasonable amount. You can’t pay them $100 an hour to file papers or something like that. And of course, the Roth IRA for everybody has an annual contribution limit. For 2019 that’s $6,000.
Those are the major things to keep in mind. As you know, there are income limits on who can contribute to a Roth IRA.
But because this is your child who probably isn’t making a six-figure income as a teenager, you probably don’t have to worry about those rules unless he or she’s a movie star.
What are the income limits to file taxes for your kids?
You know, they actually don’t have to file a tax return if they’re making under that standard deduction amount. The exception would be if you were paying them as an employee, which may or may not make sense.
But someone making $500, that’s underneath the standard deduction amount. They wouldn’t even have to file a tax return.
**Now, you know, of course, we’re not giving tax advice, we’re not giving investment advice, this is just informational. Talk to your tax advisor. **
But many tax advisors would say that you should at least document somehow that you paid this child some money.
Some tax advisors are a little more aggressive. They want to show a 1099. Some tax advisors say, “No, you don’t really have to file a 1099 for that child if they don’t have to file taxes anyway.” So, before you jump on any of this stuff make sure you talk to your own tax advisor.
What’s the benefit of using a Roth IRA for kids versus the Uniform Transfer to Minors Act (UTMA)?
This is of course case by case, but I’ll just give you a few things to think about.
If you have a UGMA (Uniform Gift to Minors Act) or a UTMA (Uniform Transfer to Minors Act) account, that’ll count as your child’s asset for financial aid purposes. Retirement assets are typically not. So, that’s something to think of.
Now, if you’re a a multi-bazillionaire or something like that, you don’t care about financial aid because your kid’s not going to get any anyway. That’s not really something to consider.
Another thing to consider is that the Roth IRA has those income tax benefits. It’s tax-free growth. Over time a UGMA, UTMA doesn’t have that type of a benefit.
Of course with the UGMA, UTMA, you do have more flexibility. Because to enjoy the tax benefits of a Roth IRA, you can’t take out the earnings. You can take out the contributions anytime tax-free, but you can’t take out the earnings until you’re 59 1/2 or you’ll pay tax on it and pay a 10% penalty.
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UGMA and UTMA don’t have those kinds of restrictions. So, it’s really a case-by-case thing but if you really are looking to set up your child not just for when he or she is in his 20’s and 30’s, but when he or she is in his 60’s and 70’s for many folks, I think the Roth IRA for kids would be the smart choice if your child has earned income.
But of course, that’s another restriction on the Roth. The child needs to have earned income on the amount that’s contributed. So, obviously, with the UGMA, UTMA, more can be put into that account.
When can you take out the contributions in a Roth IRA?
When you put money into a Roth IRA, you don’t get a tax deduction on that money. That’s money you’ve already earned and paid taxes on. So, when you put it into the Roth IRA there’s no real tax effect for simply putting in the Roth IRA.
So, when you take it out, that principal amount you put in, that amount has already been taxed whether it was wages earned as an employee or earnings of a business owner.
The IRS isn’t going to tax you on those earnings like it would for a traditional IRA that you got a tax deduction for. A traditional IRA, you got a deduction for the amount you put in. You take it out, the IRS is going to make you pay tax on that.
But with a Roth IRA, because you didn’t get that initial tax benefit, you don’t have to pay tax on what you put in if you take it out.
Is it better to focus on getting your kids through college instead of worrying about their retirement?
If you put money into a 529 plan, that growth won’t be taxed if you take it out for educational purposes which is a huge tax benefit.
But then you also gotta think. Well, the child, first of all, would have to go to college. And you know, maybe your kid is a real smarty and gets a lot of scholarships and things like that. What do you do with that 529 plan?
You could change the beneficiary to another child or maybe you change it to yourself if you want to go pursue some graduate degree or even some classes.
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But there is one thing to keep in mind: What if we don’t need to use it for educational purposes?
But on the other hand, apart from tragic circumstances, everybody’s going to retire at some point and most people could use some extra money in retirement. The other thing is you can use the Roth IRA as a college savings vehicle if you need it because you can take out what you put in. So, that’s another way to look at it.
But it’s really just balancing. I think people, they should do both. But keep in mind the Roth IRA, you’re not going to be able to fund that thing.
There’s the statutory limit of $6,000 in 2019, and then also the limit of how much your kid made.
Your kid might only make $1,000. So, it doesn’t have to be an either/or thing. It can be both.
So, I don’t think those are conflicting things but I think because the tax benefits of the Roth IRA are so great, if the circumstances are right and your kid has some earned income, might as well take advantage of that.
And then on top of that, contribute to educational plans.
Can a parent contribute to their kid’s Roth IRA?
Well, you know the parents can’t contribute beyond the amount that the child has earned income. So, even if the parents make $1,000,000 a year, if the kid hasn’t earned anything, there could be no Roth contributions for the child at that time.
This is another area where you want to talk with your tax advisor. But, let’s say your child makes $1,000 and they spend $1,000. Well, he had earned income. What if the parents just put in $1,000 bucks? I mean, many tax professionals are comfortable with that.
You know the child does have earned income. But that’s another one of those situations where you’d want to talk to a professional about it because there’s not necessarily strict guidance on that at this point.
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What are ways young kids can have an earned income?
Starting chronologically obviously as a baby, or an infant, or a toddler there’s probably not much apart from modeling or something like that. But as they get older and the child’s mental capacities expand, there are simple tasks that everyone needs done in their business.
For example, I think I mentioned filing paperwork and things like that. Maybe you have a rental property and you can bring a kid over there to help you clean it. Or, maybe they’re getting a little older now, they can do spreadsheets or respond to maintenance requests and things like that.
I would just say depending on your business, it can be anything. But I would just say, “Look, what are the lowest level tasks you do in your business? The kind of tasks that you might hire out to a Virtual Assistant (VA) right now.”
And think, “Okay, well yeah I might be able to get this VA in the Philippines for really cheap but I might be willing to pay my kid the standard U.S. wage for that work because, at the end of the day, he or she will be benefiting from it.”
So, I say when they’re young, 7, 8, 9, 10, 11, that kind of age – preteen – think of that low-level work they can do.
But then, when they enter junior high, high school, they might have some legitimate skills. Maybe they’ve taken a coding class or something, and if you have a website they could do some of that development work. Or, maybe they’re a really good writer and they could do marketing for your business.
So, it’s really anything. But the important thing is you can’t pay them some crazy wage for the work they’re doing. It has to basically be what you’d pay another person in your geographical area to do.
Like you have a home office or something and, “Yeah, the kid cleaned the house today, that’s $500.” Unless you have a mansion – but your home office probably isn’t the whole house. So, just be reasonable.
I mean, you kind of know if this is crossing the line and if you’re honestly not sure, ask your tax pro about it.
Where’s the best place for a parent to open a Roth IRA for their kids?
The ones that I’m sure you probably talked about in the show before:
They have the capacity for you to open a Roth IRA for your child. Basically, all the major discount brokerages.
Have you gone through this process for your child?
No, my only child is 6 weeks old, so I don’t want any modeling contracts yet. It’d be pretty tough for the baby to have earned income.
But you know, one thing here that popped into my mind, and this is another thing you’d want to talk to your tax professional about. I was talking to another tax pro who works a lot with influencers, like social media influencers and things like that, and one of his clients, she posts a lot on Instagram and most of the stuff is her kid.
It’s that cute face that’s getting the clicks and she’s earning some affiliate revenue. And the baby’s very young, it’s under a year old.
So, he was contemplating recommending, “Well, pay this kid!” You know, but I haven’t… That’s something you’d want to talk to your tax pro about, as well, just to kind of see what’s appropriate there and how they feel about that position.
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