IRAs For Children: A Head-Start On A Young Person’s Retirement

Parents typically encourage their children to save for college, for a house or simply for a rainy day. Saving for a child’s retirement, however, is a much less common goal. Too many other expenses are at the forefront. Yet, helping to plan for a young person’s retirement is a move that many astute families are making. Individual retirement accounts (IRAs) for income-earning minors and young adults offer a head-start on life-long financial planning. Through investing in an IRA, a young person’s earnings from working part-time at the local video/dvd rental store, or a summer job loading trucks, can contribute to the quality of life of their retirement years.

IRAs

Two types of individual retirement accounts exist. They are the traditional IRA and the Roth IRA. To contribute to an IRA, whether it’s a traditional or a Roth IRA, an individual must have earned income. This can disqualify many children. In general, the maximum annual amount that can be deposited in either type of IRA is the lesser of earned income or $3,000 in 2004; and $4,000 in 2005 through 2007 (Note: Gone are the days when the earned income limit on contributions was set at 15 percent of earned income, which in practice removed the effect use of an IRA for most children).

Traditional IRA

Contributions to a traditional IRA are tax deductible. Earnings are not taxed until a distribution is made. If money is withdrawn from a traditional IRA before the individual reaches at 59 ½, Code Sec. 72(t) imposes a 10 percent penalty (with exceptions, noted below). With a traditional IRA, mandatory withdrawals are required when the individual reaches age 70 ½.

Roth IRA

Contributions to Roth IRAs are not tax deductible but all contributions and earnings are tax-free when the money is withdrawn from the account, if certain permitted-withdrawal-events occur. Tax-free withdrawals are a big advantage that may outweigh the lack of a tax deduction on contributions, especially for a child who is usually in a low tax bracket (remember, the "kiddie" tax does not apply to the extent a child has earned income). Unlike the traditional IRA, individuals can make contributions to a Roth IRA even after age 70 ½.

Roth five-year period

Qualified distributions from a Roth IRA are not included in the individual’s income, nor are they subject to the 10 percent early distribution penalty, if a five-year holding period (discussed below) is met. To satisfy the five-year holding period, Roth distributions may not be made before the end of the five tax years beginning with the tax year in which the individual first made a contribution. Generally, one five-year period applies to all of the Roth IRAs the individual owns.

Penalty flexibility

Exceptions, sometimes referred to as the "72(t) exceptions," authorize early withdrawals, without penalty, if the money is used for:

• College expenses;

• First home purchase (up to $10,000);

• Medical insurance in case of unemployment for a certain amount of time; or

• Expenses attributable to disability (Roth IRA).

Although designed for retirement planning, this flexibility makes Roth IRAs very attractive for young adults.

Example

Tax-free earnings and withdrawals make Roth IRAs particularly attractive as a retirement vehicle for young individuals. If Chip, at age 14, puts $3,000 into a Roth IRA every year for five years (at a modest five percent interest), the money will grow to $21,200 for college. But if he keeps the money in the Roth (and continues to make annual $3,000 contributions) until he’s 25, he’ll have $50,000, of which $10,000 could be used to make a down payment on his first home. However, if Chip stays the savings course, his Roth IRA will yield $560,000, tax-free, when Chip retires at age 60.

It is important to note, however, that while using the traditional IRA to pay for higher education expenses avoids the 10 percent early distribution penalty, regular income tax on the distribution is not avoided.

Working for Parents

To contribute to an IRA, a child or young adult must have earned income. In other words, the child generally needs a W-2 or a Form 1099. Although occasional babysitting or lawn-mowing is generally ignored as income (and exempt for FICA/"Nanny" taxes), the money made from those jobs can qualify as earned income if adequate receipts and records are kept.

Some parents, who own a business, are taking the "kiddy IRA" concept one step further. Their sons and daughters come to work for the family business. The child earns income, making him or her eligible to contribute to an IRA. The parents, as the employer, must issue a W-2 (and pay FICA taxes unless the child is under 18 and working for an unincorporated family business). They can also take a business deduction for the child’s wages, just like for any other employee. Parents should be mindful that the wages the child earns for the work performed is comparable to the going rate. If the child’s wages are too generous, the IRS will disallow the deduction.

Let’s Make a Deal

The tough part of the plan may be getting the young person to "lock away" his or her hard-earned cash. After all, retirement seems so far away when you’re a teenager and is much harder to imagine compared to more pressing, front-burner issues like college expenses or buying a car.

Some parents, however, are convincing their kids to put their earnings to work for their future in an IRA by promising to match (or partially match) the child’s pay. For example, if Susan earns $3,000, her dad promises to put $3,000 in her IRA. Susan keeps the money she made.

There’s no rule that restricts the origin of the IRA contribution, so long as the owner earned at least that amount and the contribution doesn’t exceed the cap for that year. However, parents should avoid the temptation to add a "little extra" to the child’s IRA. Annual contributions to either a traditional IRA or a Roth in excess of the allowable amounts ($3,000 in 2004 and $4,000 in 2005) are subject to a cumulative six percent tax.

One Potential Hazard

IRAs for children and young adults are an important part of family financial planning. However, one potential hazard must recognized. The money in the IRA belongs to the child. The owner of the IRA can do whatever he or she wishes with its assets, including making a withdrawal for a new car or a trip.

Parents do not "own" the IRA, even if they match their child’s contributions. Families who utilize IRAs for their offspring will have to consider that risk.

Please contact Feeley & Driscoll's Boston Accounting team by Email or call us at 1 (888) 875-9770.

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