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Fundranker Blog—Roth IRA for a Child

Roth IRA for a Child

There is plenty of controversy over the relative merits of traditional IRAs and Roth IRAs for worker-age individuals who qualify for both. In general, you get to deduct contributions to a traditional IRA up front, but you pay taxes when you withdraw money from it after age 59Ĺ on both your contributions and whatever gains accrue; you donít get to deduct contributions to a Roth IRA up front, but you donít have to pay taxes after age 59Ĺ when you withdraw money from it on your contributions or any gains that accrue. Many variables make the decision very difficult to quantify, and some of the questions that arise canít be answered without a crystal ball, such as what tax rates may be like in the future when you withdraw money from your IRA.

But what about that babysitting or lawn mowing money your child makes while she is in middle school or high school? What about that first part-time job she gets at the corner drugstore? Itís pretty likely that with her income level, she wonít even have to file an income tax return, and yet this income is considered after-tax income. You couldnít ask for a better situation for a Roth IRA to make sense. Your child wonít pay income taxes on the income, but she can take full advantage of a Roth IRA. Plus, that money will be in your childís Roth IRA for a long, long time; time during which it can grow and grow and grow.

Your childís Roth IRA contribution for 2009 (contribute by April 15, 2010) is limited to her earned income or $5,000, whichever is less. With the jobs weíre talking about, she is likely to earn less than $5,000. So do you ask her to give up her hard-earned money, which, since she made the effort to earn it, she must want for something else? Well, that depends on your situation. If you think getting your child set up with a life-long investment is important, and you have the means, you can spring for all or most of the money to put in it (you can give up to $12,000 per year to an individual without the gift being taxable). After all, it probably wonít be a large amount the first few years.

You are probably asking, what if my kid only makes $50 babysitting the first year she makes any money? Check with your bank or credit union to see what their minimum requirements are for opening a Roth IRA. Many have very low minimums, so you can start very small.

Because a Roth IRA is not considered for FAFSA (Free Application for Federal Student Aid), it is a great way to save in your childís name, shield those assets from financial aid considerations for college, and yet still have access to at least some of the money for college, as follows.

Your child can make certain withdrawals from her Roth IRA before age 59Ĺ without including the amounts as taxable income or having to pay a penalty: for example, she can withdraw any or all of the contributions she makes over the years, or she can withdraw up to $10,000 for qualified first-time homebuyer expenses, even if they exceed all of her contributions. Investment earnings that accrue in a Roth IRA are another story; if your child withdraws earnings (other than as qualified first-time homebuyer expenses) from her Roth IRA before age 59Ĺ, she will have to include those amounts as taxable income and will have to pay a 10% penalty, as well.

Setting up a Roth IRA is a great opportunity to teach your child the importance of saving for the future. Show her how her Roth IRA may grow over the years from her contributions as well as investment returns. Review various ways her Roth IRA can be invested and decide together which to use. If you want your child to feel more ownership of her Roth IRA, you and your child could agree on a “company matching” strategy, where you play the part of the company and do the matching (probably way more generously than your company matches your 401K), and your child puts in some part of her earnings.

Posted 5/12/09 11:57am ET in Investing, Tax Tips

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