IRA for a minor

[Guest PJRoxie]

can I establish an IRA for my 4yr old ? What are the penalties/tax consequences if I have to withdraw money in case of emergency ? What's the max that I can contribute per year/totally ?

Thanks,

PJ

[david rigby]

Does a 4-year-old have earned income (“compensation”)?

See “What is Compensation” on page 9 of this publication:

http://www.irs.gov/pub/irs-pdf/p590.pdf

[dh003i]

pax writes:

Does a 4-year-old have earned income (“compensation”)?

Interesting question. I'm no lawyer, and I'm not inclined to look these things up, so I'll pose questions for more legally knowledgeable people to answer:

• Can a 4-year-old have an earned compensation?
  
• If so, for doing what?
  
• If so, is paperwork necessary?
  
• If so, how much compensation can he have?
  

I remember reading in a magazine that a certain self-employed couple employed their son over the summer to do trivial things, paying him $3000, which they put in a RothIRA.

[BPickerCPA]

Child actor or model is about it for a 4 year old. There is no reason why a parent cannot hire a child (I believe that in some if not most states, working for a parent does not run afoul of child labor laws). However, the child must actually perform work and the compensation must reflect the market value of the services.

Besides the economics of it, it's not a bad idea if it helps to give the child a sense of responsibility as well as actually giving the child some skills. My kids can handle data entry as well as anyone, and they have also learned how to properly answer phones and take messages, which is sadly a lost skill among many young people.

[dh003i]

BPicker, some great stuff. Regarding child-actor/model, how strict are the requirements? I mean (if I had a child) I would pay my child $3,000 dollars to "star in a home movie" doing what s/he does everyday.

The more difficult thing is that the pay the child gets must reflect the market value of those services. How is a child going to provide services to you that you could justify giving them enough money to make a dent in their future retirement or college expenses? How is fair market value determined? After all, it is very possible in the real world that someone can get paid alot more money than the fair-market value of what they do, yet that is fine and dandy. In other words, how strict is the IRS about this type of thing?

I agree with you that, economics aside, it is a good thing to give children responsibilities and rewards for fulfilling those responsibilities. It is pretty sad that some young people can't properly answer phones and take messages. One of many skills being lost (they now offer classes on politeness). Another thing that bothers me is that things like managing one's financial life aren't taught at all in school. Classes about std's are mandatory, but classes about how to balance a checkbook and otherwise properly manage one's financial life aren't even available in high school, nor are classes on reading and understanding laws.

[John G]

Clarification: the child needs "earned income". Dividends, interest, capital gains or gifts do not count.

I concur with Barry. At age 4, there is little that a child can do to earn money. Model or child actor is about it. You often see the children of entreprenuers in their TV ads (Buy a car from my dad!) and is reasonable for the child to be paid for participating. This means the child could have W2s and would be filing a tax return (the paperwork that Pax is probably refering to). This is one of the benefits a small business has over a payroll worker.

Teens are much more likely to have earned income. This can include a newspaper route, babysitting, dog watching, yard work, and my favorite selling lemonade on a hot day. You can make a more convincing case of hiring them for a small business. From age 15 on, my kids have been paid for filing, copying, shredding and cleaning to give them a small income to qualify for Roths. The Roth contribution does not have to come from the kid's account, but they must qualify based upon their own earned income.

You may want to consider other kinds of savings or investments for a 4 year old child. You could be the custodian for a tax managed or index mutual fund. You could buy stocks and hold them for a long term (to avoid tax events. Some colleges/states have prepaid tuition plans. There is a range of "529 Plans" and also the Coverdale Plans (also called Education IRAs). Some of these are flexible and good, some are just awful. Here are some website references on minor investing.

http://www.nasd.com/Investor/Choices/Colle.../529_saving.asp

http://www.kiplinger.com/tools/managing/co...1/states01.html

http://www.ici.org/ici_frameset.html

You will also find Fidelity, Vanguard, Twentieth Century, Scwab and a host of other mutual fund families and brokerage have their own plans.

Some key things to consider: how flexible are these plans, will the plan maximums meet the anticipated goals, when (if) the child gets control of the funds, what are allowed expenditures, what investment options are offered, fees, can they be shared across family members or are they child specific, and what happens if the child does not go to college.

[dh003i]

I used to think that people who had their children model or act were exploiting them. However, now that I realize that enormous tax-advantages and eventual education-expense advantages that such children can get, it is conceivable that parents could do this for their child's benefit (indeed, certain, if the parents use that money for these education benefits).

Some other considerations. I trust that most people are thinking mostly of education for their children when saving. Here's some information I've acquired on saving for children's education:

• Uniform Gifts to Minors Act/Univform Transfers to Minors Act (UGMA/UtMA). Tax-free gifting of money/assets to children. You manage the money until the child reaches the "age of maturity" (ha). Taxes on gains are negliigible until the account reaches $1,400, at which point it is taxed at the parent's highest maginal income-tax rate. When the child reaches 14, the gains are taxed at the child's lower rate. UTMA's are better, as the parent can retain control until the child reaches 25, depending on the state. Drawback: Colleges expect a higher percentage of the assets in a UGMA to be contributed to yearly tuition than the percentage of a parents assets they expect to be contributed. Thus, there is a benefit to keeping money in your own account (and not in your child's name), as it allows your child to get more financial aid.
  
• Tax deduction: If your AGI is less than $65,000 for single ($130,000 for joint filers), then you can deduct up to $3,000 ($4,000 in 2004) for education expenses.
  
• Hope scholarship: Deduct up to 100% of the first $1,000 of your child's education costs, and 50% of the next $1,000 of your child's education costs. It is deducted directly from the tax you pay, not your taxable incomoe and is, thus, very valuable. You can claim this deduction for each freshman or sophomore in your family. Phase-out range: $40k to $50k for single parenst, $80k to $100k for married parents filing jointly.
  
• Lifetime Learning Credit. Deduct 20% (40% in 2003?) of the first $5,000 of tuition expenses for your student. This one applies for juniors and seniors, and is only a per-family deduction from the taxes you pay. Phase-out range: $40k to $50k for single parenst, $80k to $100k for married parents filing jointly.
  
• Education IRA. Can contribute $2,000 for every child under 18, per year. Contributions are not tax-deductible, and have no affect on the amount you can contribute to traditional and/or Roth IRAs. Any single person who makes less than $110k or married who makes less than $220k can set up an education IRA. Maximum contributions are phased out at the upper limits. Distributions from an Education IRA are not taxed if they are used for qualified higher-education expenses. Distributions are subject to a 10% penalty and the income tax if not properly used. A beneficiary must be designated, and the Education IRA must be used before the beneficiary is 30; however, the beneficiary can be changed. If you are making contributions to a qualified state tuition program or a Section 529 plan, you cannot contribute to an Education IRA in the same year for the same child. Thus, it is important that family members providing for the education of a child coordinate efforts, so that the maximum benefits can be provided. Starting 2002, you can use an Education IRA without giving up the Hope Scholarship or Lifetime Learning Credit. Education IRA's may make it harder for your child to qualify for financial aid.
  
• Roth IRA. All the advantages of the RothIRA. Among others, you can withdraw original contributions at any time for any reason, no penalty, no tax. Can qualify for Hope Scholarshipo or Lifetime Learning Credit while child is receiving Roth IRA distributions. Child has better chance of qualifying for financial aid than with an Education IRA. By the time your child goes to college, you will be able to take your original contributions to a Roth IRA (assuming they were maximum) and pay for a significant part of the child's education. A Roth IRA will not affect your ability to fund a 529 plan. It will not reduce your child's chances of qualifying for financial aid. However, using a Roth to fund your child's college education detracts from your retirement savings, though it may save you money overall, because you child can get more financial aid. You can use your RothIRA to contribute to your child's education (by deducing original contributions). If your child has any earned income, then create on for him or her as well. If s/he doesn't, get him or her an earned income.
  
• Prepaid tuition plans. Invest in plan, and investment buys certain number of tuition credits at your state's college or university system at today's prices. This locks the price. Size of payments is determined by child's age. Typically, anyone with an interest in the educational future of the child can contribute to a prepaid tuition plan. Prepaid tuition plans qualify as completed gifts for federal gift-tax purposes. Can be used along with Hope Scholarship and/or Lifetime Learning Credits in one year. Earnings portion of these plans are exempt from federal taxes. State taxes are deferred while the money is in the plan. Payments may be deductable from annual income. Drawbacks: How do you know your child wants to go to state-school, or that you want them to go there? Only tuition is prepaid, nothing else. And investment grows merely at the rate at which school-tuition increases.
  
• Section 529 savings plans. State-run, tax-deferred savings plan allowing you to set aside money for your child's education. You can invest in a tax-advantaged manner. Anyone can put money into a 529 plan for anyone else -- even for yourself in the future. Contibutions are taxed as ordinary income, but earnings are exempt from federal taxes ifused to pay for college expenses. In some states, the taxes on earnings are tax-deferred. Colorodo, Iowa, Kansas, Louisiana (partial match), Michigan, Missouri, Montana, New Mexico, New York, Ohio, Utah, Virginia, and Wisconsin offer a state tax-deduction. You can invest in 529 plans in any state, but you only get the state tax deduction by investing in one in your own state. Money contributed to a 529 plan can be used at any accredited US college/university and even some foreign universities. There are some state-to-state variations. Typically, you can contribute $100,000 to $150,000 per student per year in a typical 529. Varies from state to state. Amounts greater than $50k/yr may be subject to the gift-tax. The plan investment is managed by the state. As of 2002, you can roll over your account to different 529 plans every 12 months, if you are dissatisfied with performance. See SavingForCollege.com. You retain ownership of the money at all times, but it must be used for education costs, or you will pay a penalty and income taxes. If your child is awarded a scholarship and you have a 529, you will usually be given back the money (earnings will be taxed). If your child doesn't go to college, the 529 can pay for any other child's college education. You can request a refund, but earnings will be taxed and assessed a 10% penalty, and if you took the state deduction you will have to repay the state. Does not disqualify you from a Hope Scholarship or Lifetime Learning Credit. Does not reduce chances of getting state financial aid, but does reduce chances of getting federal gov't aid or aid from college. Thus, consider eligibility for financial aid *before* opening a 529.