Are you worried about getting Social Security as promised? If you’re not, don’t read the following paragraph.
The Social Security Administration recently issued a message to the public summarizing The Trustees of the Social Security and Medicare trust funds report. It stated, “The Old-Age and Survivors Insurance (OASI) Trust Fund will be able to pay 100 percent of total scheduled benefits until 2033, one year earlier than reported last year. At that time, the fund’s reserves will become depleted and continuing program income will be sufficient to pay 77 percent of scheduled benefits.”
If you think you’ve got it bad, imagine how things look for your children and your grandchildren. Will Social Security even be around when they retire?
If you have concluded you shouldn’t depend on the kindness of government for your and your descendant’s retirement, congratulations, you’ve taken the first important step to protecting your family. Now you can move on to the next step and actually start doing something about it.
Have you started a 529 plan for your kids? If so, there’s a new way to use it to save for retirement. You can read about it here. If you don’t want to wait for this more-than-a-decade-long process to work, here’s something you can do right now. You can start a Child IRA for your kids. All it requires is for your children to have earned income.
What is considered earned income for a child?
A Child IRA is just like an IRA you’d set up for yourself. The only difference is how it’s set up. But it still necessitates the IRA contributor (in this case, the child) receive employment income during any year contributions are made. Believe it or not, this may be easier than it seems.
“Earned income can be a paycheck from a regular job (not many toddlers will have these), or it can be money that a kid has from self-employment,” says Boston-based Andy Rosen, investing and taxes spokesperson at NerdWallet. “If you can set your child up with a gig babysitting, walking dogs, or selling items online, they may be eligible to contribute to a ROTH IRA. Just be aware that child labor laws could limit the paid work your child is allowed to do.”
There may be greater flexibility you own a business (whether it’s full-time or a side hustle).
“A great scenario is the case where a parent operates a business that is reported on Schedule C of their tax return and their minor child is an employee,” says Robert Steinberg, founder & CEO of Blue Chip Partners in Farmington Hills, Michigan. “The child can be paid wages and the parent is not required to withhold Social Security (FICA) or Medicare. Years ago, we had a client who owned their own business and they hired their children to clean the building and do other odd jobs such as data entry. They were paid wages that were not subject to employment taxes and the children were able to open a ROTH IRA since they had wages. This special rule only works for schedule C filers and not corporations.”
If I pay my kid for chores, is that earned income?
Many parents pay their children an allowance. This might be “payment” for doing domestic tasks or other activities to benefit the family. You might wonder if this counts as income. Unfortunately, it does not.
“Income from household chores is considered as unearned income,” says Alvin Carlos, managing partner at District Capital in Washington, DC.
Similarly, money received as a gift from any source can’t be counted as the income requirement that determines how much can be contributed to a Child IRA.
“You can’t use a gift as earned income for this purpose,” says Rosen. “The money has to come from work. So if you’re thinking about simply writing your kid a check and then using it for a ROTH IRA, you’re out of luck.”
What is the best retirement plan for kids?
Minor children who have started their own businesses will often find it useful to consider setting up SEP-IRAs or so-called “Solo” 401ks. This is most likely an option for enterprising teenagers. In general, however, the standard IRA represents the best way to create a Child IRA.
It then comes down to a choice between using a traditional tax-deferred IRA or an after-tax ROTH IRA. Given the probable income levels of your child, you’ll find the ROTH option offers the greatest benefit.
“If your child earns less than the standard deduction ($12,950), your child will not owe any federal income taxes on their earnings,” says C. Ryan Quinty, a financial advisor at Cyndeo Wealth Partners in Saint Petersburg, Florida. “In cases with very low income like this, it is best to open a ROTH IRA.”
Even if your children have to pay taxes on their income, the benefit of deferring taxes today may not be enough to offset the advantages of withdrawing tax-free during retirement.
“Assuming a low tax rate (not a Hollywood star), then a ROTH IRA makes the most sense,” says Steinberg. “The value of the tax deduction for a minor is likely small, but the benefits of lifetime tax-free accumulation are significant.”
At what age can I start a Roth IRA for my child?
How old should your child be before you start thinking about setting up a Child IRA? It might surprise you to learn there is no age limit.
“The youngest age to open an IRA is birth, as long as the child has earned income,” says Andrew Latham, director of content for SuperMoney.com in Santa Ana, California. “Of course, it’s rare for young children to earn income unless they are paid for the work they do as a model, actor, or performer. The key to qualifying for an IRA is that you earn income and that the income must be earned through some form of labor or service, as opposed to being gifted or inherited. The child must have earned income equal to or greater than the contribution amount to make a contribution.”
In all cases, however, you’ll need to sign the documents on behalf of your child. Minor children may not enter agreements, so an adult (i.e., a parent or guardian) must act as their custodian for these accounts.
“To set up a Child IRA, connect with your bank or brokerage firm and follow their instructions for opening a custodial IRA,” says Kimberly Bridges, who is a senior vice president and director of financial planning at BOK Financial
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Financial firms may use different names for these accounts. They could be called “Child IRAs,” “Minor IRAs,” or “Custodial IRAs.” They may also just be called “IRAs.” You’ll need to make it clear what you intend to do.
Guiding your children on the path of starting a Child IRA will be their first step toward financial independence, no matter what happens to Social Security.
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