Few of the financial topics that I write about elicit as many questions as Roth IRAs for kids. Over the next couple of weeks, I'll try to clear up as much of the confusion as I can.
Question: Recently my wife and I found out that we were having a baby. The next day, we also realized that our tax bill was going to be bigger than we had expected. Can we shelter some income by setting up a Roth IRA for our child when he or she is born?
Answer: Now hear this: The most important prerequisite for opening a Roth IRA is earned income. You can't open a Roth for a child with no earnings. And investment income doesn't count.
Let me introduce you to a family that did it right. Justin Bier, 18, started doing odd jobs in his father's Edison, N.J., podiatry practice when he was 13. His dad, Robert, paid him an hourly wage and helped Justin use his earnings to open first a traditional IRA and then a Roth when it became available. Now that he's 18, Justin plans to go right on maxing out his annual Roth contributions.
Question: If I pay my daughter a regular allowance in exchange for doing chores around the house, can she use that money to start a Roth IRA?
Answer: Don't even think about it. While it's legal to hire a child to do a specific job in your home, an allowance likely won't pass muster with the IRS. There's a fundamental difference between, say, a domestic employee who regularly cleans your house from top to bottom and a child who is asked to make his bed and tidy his room.
The IRS hasn't issued much guidance in this area, but "I sure as heck wouldn't stick my neck out if I were a parent," says an IRS spokesman.
Income from a steady job such as baby-sitting or lawn mowing does count as earned income. But it's better if your child does work like that for neighbor families rather than for your own. In any case, it's critical for kids to keep meticulous work records if they're not getting a W-2.
Monitoring kid IRAs may not be a high priority for the IRS. But if your child's account doesn't meet the legal criteria, money you put into it is considered an excess contribution. You can incur a penalty of 6 percent a year on that money and any earnings on it as long as it remains in the account.
Have a question about kids and finances for Dr. Tightwad? Write to Dr. T at 1729 H St., N.W., Washington, DC 20006. Or send the good doctor an e-mail message (and any other questions for this column) to jbodnar@kiplinger.com.