Yes, you can start a Roth IRA for your child, even if they’re a baby! All they need is earned income— but the definition of earned income is tricky. Here’s how to navigate that minefield.
A reader writes:
I think you mentioned before that you set up an IRA for your daughter. How did you account for wages and a W-2? Did she work for you or earn income from someone else? I’ve set up a Roth IRA for our teen for work done around the house, but my accountant is telling me that is very unusual and may be ripe for questions.
Please send this post to your accountant. Perhaps kids’ Roth IRAs are unusual because parents don’t realize it can be done!
In our case, it wasn’t just about the money. It turned out to be long-range planning– both financially and for raising a money-smart kid.
Before I get into the details and how you can do the same for your kid, let me address two very common concerns:
- All of this is perfectly legal. Like any other tax planning, starting your kid’s Roth IRA will only trigger an IRS audit if you get greedy. I’ve included the references so that you can check them against your situation and with your own accountant.
- The federal government and the college financial aid offices will not penalize your family or your child for having a Roth IRA. The reality is that you’re “penalized” even more for putting assets into a 529 account or a kid’s trust– although those are good tools too.
I’ll admit it up front: we parents made our plans on the fly. When our daughter came up with an idea, we’d figure out a way to sneak in a life lesson while helping her turn her idea into reality. Other times I’d stumble across an idea, research it, and then tweak it to motivate our daughter. If you start a Roth IRA for your kid then you‘re also responsible for teaching them how to use it. They’re not ready for IRS Publication 590 but they’re certainly ready to learn about jobs and saving money. By the time they’re old enough to figure out how to cash in their Roth IRA in for a BMW, you’ve also taught them why that’s a horrible idea.
What we did
It all started in first grade. Our daughter was a good student, but she didn’t like homework.
Luckily her elementary school had a Kumon franchise on the premises. After the school day ended she’d see several of her friends trot over there (with their cool Kumon worksheets & backpacks) for tutoring on their math & reading exercises. It was an exclusive club! One day she told us that she was having problems understanding her numbers and she needed to go to Kumon to learn better math. Our kid was asking for more school.
It seemed like a good idea at an affordable price. Here‘s the “parenting on the fly” part: we told our daughter she wasn’t ready to do Kumon. Kumon has homework every. single. day. but she didn’t want to do her school homework. She would have to do better on her school homework before she could start Kumon.
The homework battles immediately disappeared (she really wanted to go to Kumon with her friends) and next week she picked up her own set of cool Kumon gear. She did Kumon almost constantly until she graduated from high school. It’s one of the key accomplishments that got her into a top-10 engineering university with a full-tuition scholarship. Those monthly Kumon fees were a drag on the budget but they had a huge return on the college fund.
Kumon also has role models: the owner and her employees. We kept pointing out that the owner was running her own business, and she used our fees to pay the teen tutors. As our daughter got older, she dreamed about opening her own Kumon business. Even better, the teen tutors were getting paid over $7/hour to show her how to do algebra.
The day our daughter turned 14 and could get a work permit, she started her part-time job at a Kumon tutoring center. She’s earned over $2500 per year every year since then.
Starting the Roth IRA account
Our daughter started her Roth IRA with W-2 earned income, and she earned more through family labor: rehabbing our rental property, washing cars, yard work, babysitting, even “apprentice” labor on wiring electrical sockets and fixing toilets. If we could figure out a way to pay her for work then we added it to her Roth IRA.
I researched articles about setting up a kid’s Roth IRA. (More recent articles are linked in the “Related articles” section at the bottom of this post.) IRS Publication 15 says that parents paying their children under 21 as “family employees” don’t even need to create W-2s or 1099-MISCs. (See Chapter 3 on page 12 of that link.) I kept payment records in Quicken (along with all of our other family spending) so we have the data if necessary. TurboTax never complained about the tax rules– in fact, it encouraged her to set up a Roth IRA with her earnings.
The biggest challenge was finding an investment firm that would sub-custody a Roth IRA for a minor. I talked with several companies before T. Rowe Price agreed to open an account in her name with me as the adult custodian. (TRP’s funds also had higher expense ratios and quarterly fees, so today I’d probably start with Vanguard.) As soon as our daughter turned 18 she moved her Roth IRA to Fidelity (for their Spartan fees).
The intangible benefits of a kid’s Roth IRA
Education became an important part of the Roth IRA when our daughter spent her first Kumon paycheck on her own cell phone. She pointed out that she was missing plenty of teen networking about homework and study groups, and her new cell phone solved that problem for about $20/month. It also taught her how many hours she’d have to work to pay for her needs & wants.* She learned tricks about cheap calls and texts and applied that frugal attitude to her entire budget. She really enjoyed the phone, but she was keenly aware of how quickly it would chew through her paycheck.
We taught her about saving for retirement. That motivation was easy: if she wanted to retire in her 40s like her parents, then she needed to start a Roth IRA now. We also talked about how her Roth IRA would compound if she maximized her contributions, and we even built a spreadsheet to play with the numbers. After a few of those talks, she agreed to put as much as she could into her Roth IRA and we parents agreed to match some of her contributions. She still had to earn the income from her Kumon work and side-hustle jobs to be able to put it into her Roth IRA, but she got to keep enough of it to stay motivated. By the time she finished high school, she was maximizing her Roth IRA contributions.
Two important points helped her stay motivated: she loved her Kumon work and she had good mentors. She was teaching young kids, making friends with the other tutors, and being treated very well by her boss. We parents showed her that she could retire in her 40s, and she saw plenty of “negative” adult financial behavior.
Her Roth IRA education would have been much more difficult if she was cleaning toilets at the movie theater while we parents were setting poor financial examples. She also knew how many hours she’d have to work to buy a Macbook, so it helped her control her spending. Her attitude was not “Yay, I have $20K in my Roth IRA– let’s go car shopping!” Her behavior was “I worked for hundreds of hours to get this money, and I’m not going to waste it.” There was plenty of teen socializing on the beach, not so much at Starbucks.
During 2008-09 she learned a powerful lesson about investing in volatile markets. She was quite upset to watch her S&P500 index fund drop over 40%, but it gave us plenty of opportunities to talk about the family finances (her investments were doing better than ours!) and to use dollar-cost averaging. She lived through a recession and got plenty of financial reassurance at a very impressionable age, and she didn’t have to pay fees to an advisor. Today when the markets go down, she cheers with Warren Buffett about equities on sale.
Other details you need to know
Earned income can come from just about any source, and at any age.
Starting a Roth IRA for your kid is straightforward if they have W-2 or 1099 income. I’ve read of babies and toddlers being paid by agencies as photo models.
Kids with W-2 or 1099 income may also need to file an income tax return. (IRS Publication 929 lists the requirements for filing a child’s tax return.) They might not need to pay taxes on their income, but they’d file a return at the very least to get a refund of any money that was withheld by the employer. The standard deduction on the kid’s income-tax return might mean they won’t owe income taxes and can still get back all of their withholding.
Even if your kid is not required to file an income tax return, filing is by far the easiest way for them to document their earned income for a Roth IRA contribution.
Filing a return is also a very powerful teachable moment for a kid to learn about paying income taxes, even if they’re just clicking the buttons on the software’s interview questions. The software shows how much they earned and how much could go to the government, which helps them pay attention to the tax consequences of their earning & investing choices.
Can I hire my kids in my business?
The easiest way for kids to earn an income is to employ them in your family *business* (if you have one), and that’s generally exempt from self-employment tax. (Check with your CPA.) Bloggers and landlords are notorious, er, I mean, famous for this. Kid jobs include:
- Rolling change from coin-operated laundry machines.
- Cleaning the rental property and mowing its yard.
- Baby models ($25/hour) for photos in your blog posts or product sales.
- Partners on YouTube videos.
These days, my daughter and I regularly use her baby daughter’s photos in social media. An hour per week is $1300/year in Roth IRA contributions for a toddler who still consumes far more than that in diapers.
A local friend pays his kids to set up his websites (and run them) for his side-hustle businesses. (He also pays them a modeling fee for using their photos on his business marketing and the websites.) Teens who enjoy writing or blogging can build an audience on a popular topic and run advertising.
One blogger even paid their unborn for “baby modeling” of sample sonograms in picture frames that were sold in an eBay store. Of course this particular Roth IRA contribution had to wait until the baby was born and had a Social Security Number. The timing was critical, because the baby had to be born during that calendar year and everything else had to be accomplished before 15 April of the year following the “sonogram modeling.”
There are two key points for paying kids in the family business:
- Document their labor. This is as simple as a notebook with date, task, hours worked, and pay. That’s good enough for the IRS, and anything more complicated is for your convenience.
- Be careful with your business deductions. If you take sketchy deductions for your kid’s labor then the IRS matching computers will start with a query letter (to the parents) about the business. The audit will follow those deductions into the kid’s income for Roth IRA contributions.
One family lost a Tax Court case over their business deductions. During the prosecution process, their record-keeping for the family business annoyed the IRS so much that the parents lost some of the kids’ Roth IRA contributions as well.
This family had deducted the expense of paying the kids to clean the kennels of their dog-breeding business, which was legitimately earned income for a kid’s Roth IRA contribution. However, they also deducted the expense of paying the kids to clean up the family kitchen (where dog food was prepared) which the Tax Court determined was a family chore. Part of the dispute was that the family kept poor records and mixed their business jobs with household chores charts. It was not clear whether the kitchen cleanup happened after the family dinners or after the dog dinners.
This Roth IRA issue was not caused by the kids or by their earned income— it grew out of the sketchy business deductions. The Tax Court ended up going after parts of the kids’ Roth IRA contributions because some of the family business deductions (for paying the kids their earned income) crossed the line from “aggressive accounting” into “illegal.” There was also evidence that the parents might have created some records after the fact.
Note that you, the parent, don’t have to issue a W-2 or 1099 to document your kid’s income for a Roth IRA contribution. You (or your accountant) might choose to do that for your own business reasons (especially for expenses, other deductions, or withholding) but you can document the kid’s income with as little as a work log. Simply record (on paper or on software) what they did, when they worked, and what they were paid. Make it as easy as possible for you to make (and keep) good records.
Let me be clear: you don’t need elaborate and rigorous accounting systems to document the earned income for a Roth IRA contribution. There’s no requirement to do so. Just make sure it’s earned income (check IRS Publication 590 for the current tax year) and then keep a simple record of it. The simpler that you make your record-keeping, the more likely you are to do it right. The IRS will hold you to any extra self-imposed requirements that you put on yourself, so don’t make it hard on yourself.
The IRS might come after you if you’re taking dubious deductions for your family business, or if you’re not keeping a record of those deductions, but they won’t come after a Roth IRA contribution made from legitimately earned income.
What if the parents don’t have a family business?
Kid entrepreneurs can contribute to their Roth IRA when they have self-employment income (neighborhood yard care, dog-walking, and babysitting). However, they may also have to pay self-employment taxes if their net income is at least $400. A kidpreneur will probably need your help (or your accountant’s help) to make sure they take every legitimate deduction against their gross income. However, they can still contribute all of their earned income to their Roth IRA, up to the Roth IRA contribution limits.
If they’re younger than age 18 then they could also be the only worker in your new family business, while you’re the parent/owner who helps them with the finances. I’ve read of teens recording videos (makeup skills, video game hacks) and earning a share of the advertising revenue from their YouTube channel. When they turn 18, they can do it in their own name and you no longer have to run a family business for them.
Can I pay them for jobs around our house?
Maybe. It’s aggressive and borderline, but you might be able to justify it (and document it). You’re contemplating tap-dancing into a minefield here, but you might still cross it safely. (Without me!) It might also be easier for you to start a family business than to debate “jobs around our house” with the Tax Court, but let’s dive into the details.
The short answer is that your kids have to be paid for a job that you’d outsource to any other neighborhood kid (or to a contractor) and not for typical family chores. Your kids can receive earned income for painting the house, mowing the lawn, and maybe even washing your car— especially if you’ve never done those jobs on your own and you’ve always hired them out.
If there’s not a family business then the IRS might disagree that your payments to your kids are earned income. Here’s more guidance from Fairmark. It’s a slippery slope. Paying your kid for teaching piano lessons or martial arts to their siblings is probably earned income. Paying your kid to babysit their siblings might cross the line. It’s earned income if they’re washing the car by themselves instead of you taking it to the car wash. It’s probably not earned income if you’re washing the roof of the pickup truck while they wash the wheels. It’s earned income if they’re cleaning the kitchen and bedroom in your investment rental property between tenants. It’s definitely not earned income if they’re cleaning the kitchen or their rooms in your primary residence.
Paying family members for household chores is not earned income, so it can’t be used to support contributions to IRAs. You can pay your kids to make their beds and clean their toilets, but it’s not earned income. However, if you pay your kids to make your bed and clean your toilet, then it’s probably earned income. Have fun with that one, and maintain your records.
Here’s another example of a parent who’s done the research, yet their payments to their three-year-old might be pushing the envelope. If they maintained their documentation then the IRS would probably close the query without even escalating to an audit. You’d absolutely want to review these posts with your accountant to see if they pertain to your particular family situation.
I’m going to beat this one into the ground: if you don’t have a family business, then be contemporaneous about documenting your kid’s earned income. A paper notebook in pencil (or even crayons!) is still fine, but the jobs have to be outsourced labor and not typical family chores. Don’t wait until you get a query letter from an IRS computer and then start “retroactive creation” of the employment logs.
Just so you know, the IRS has already been told how much money went into a kid’s Roth IRA. The IRA custodian reports the contribution (and the value of the Roth IRA) with the kid’s Social Security Number to the IRS on Form 5498.
What if my kid wants to spend their earned income?
First, congratulations! You’re winning at both adulting and at parenting. Your kid has earned income, and you’re sharing a teachable moment about choosing between immediate gratification or investing for the future. No matter what your kid decides to do, it’s their earned income and you helped them talk through their options. You’ve done your part.
You could still attempt blatant bribery your parental jiu-jitsu.
This is yet another reason to have a family business: as a condition of your kid’s employment with your business, you could require that all of their earnings are contributed to their Roth IRAs. Make that nepotism work for you— and for their future.
For example, your worst-case parenting scenario would be sternly ordering your progeny to put all of their earned income into their Roth IRA. (Good luck with this authoritarian confiscatory approach.) Your kid would, at best, appear to submit (actually with “malicious compliance”) and would probably cash in the IRA as soon as they left your household. Not, of course, that I ever did anything like that when I was a teen.
You have better (and more authoritative) options. With some kids, you could show them the spreadsheet of the difference between contributing to a Roth IRA at age 12 and at age 22. Your kid might immediately grasp the compound math behind a 10-year head start and run with it. If you already have a future Warren Buffett in your household then you’d tell them to build their own spreadsheet to prove it to themselves.
Ultimately, though, you’d have to align your child’s short-term financial hormone urges with your long-term goals. One way to achieve this is a form of bribery: the (totally legal) technique of gifting.
Per the tax code, anyone can gift anyone else a limited amount of money per year (up to $15K in 2021) with zero tax due and no paperwork. Your kid could contribute their earned income to their Roth IRA (the lower amount of their earned income or $6000 in 2021) and you could motivate them afterward by gifting them. (They’ve earned your gift for demonstrating such outstanding deferred gratification.) You could still gift them more if you wanted, but most parents would gift them up to the amount that they stuffed into their Roth IRA.
Ideally, a child would maximize every Roth IRA contribution and let it compound for decades. However, a Roth IRA can help save for college, and it’s more useful than a 529 if your child decides not to go to college. A teen’s Roth IRA will not affect the family’s eligibility for financial aid because retirement accounts are not included in the calculation. Not only that, but while college financial aid programs will generally assess other student’s assets at 20%-25% per year for their expected financial contribution, their Roth IRA is not included in this formula. The contributions to a Roth IRA can be withdrawn at any time for any reason without additional tax or penalties (whether it’s for textbooks or a cup of coffee), and Roth IRA earnings can be withdrawn penalty-free for educational expenses. Be careful with these decisions, though– a student’s withdrawals from an IRA could be considered as income that would count against their financial aid for the following year. It’s better to avoid using the Roth IRA for college expenses, and it’s best to keep contributing to it.
One of the first financial chores for a college graduate is setting up their own emergency fund. Instead of leaving that emergency fund in a checking account or a “high-yield” savings account, they can contribute it to their Roth IRA. Contributions can be withdrawn at any time for any reason, so they can put the money to work (perhaps in a bond fund or a blue-chip stock fund) and still sleep comfortably at night knowing that they can tap an emergency fund.
On their own
When our daughter started college, she kept on working. (As far as I know, work came after she finished her homework & studying!) She enjoyed giving campus tours ($12/hour, documented on a 1099-MISC), and during winter/summer breaks she’d rack up more hours at Kumon. She also kept doing jobs and projects around the rental property with us, so she kept reporting it on her tax returns. We parents kept matching her contributions during college (as long as she had the earned income) so that she could maximize her Roth IRA while still having some spending cash. When she turned 21 years old, however, she aged out of the “family employee” category.
Yes, she eventually bought a car. But she didn’t touch her Roth IRA.
When she starts her new job after graduation, you know that she’ll be maximizing the contributions to her retirement accounts. She’s also very focused on how long it’ll take her to reach financial independence, and her Roth IRA puts a great foundation in place to reach that goal at a younger age than her parents.
[* She convinced us that a cell phone is a tool. We bought her an iPhone for her 17th birthday and we’ve footed that bill during college. It’s absolutely essential on campus.]
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