Tuesday, March 16, 2010

The Roth IRA – Not Just For Grownups Anymore!

Did you know that there is no minimum age requirement for starting an IRA? Did you know that you could actually start an IRA for your child while the child is still a minor, even if the child is a newborn? Talk about a creative retirement plan. This isn’t something new; it’s just that, for the most part, people don’t know about it. I know I didn’t!

The catch is that the child needs show verifiable earned income. There are also other restrictions associated with IRAs, for instance, you must fall within a certain income bracket to be able to qualify for one, and you can only contribute up to a certain amount per year; however, right now you are probably just wondering how in the world are you going to get verifiable earned income for your child in the first place!

Here are some general examples of ways children can earn income (just to show that it is possible and to give you some ideas):

Selling Products
  • Lemonade stand
  • Bake Sale
  • Crafts
  • Modeling Fees
  • Lawn services
  • House Cleaning
  • Baby Sitting
Roth IRA or Traditional IRA?
If your child were able to get verifiable earned income and you were thinking about getting him an IRA, then the Roth IRA is the way to go. With this type of account, original contributions can be withdrawn at any time for any reason. (That said, earnings generally cannot be withdrawn before age 59 1/2, without triggering taxes and a penalty.) Granted, it's pretty much always a better idea to simply let the account grow until retirement, at which point withdrawals can be taken completely tax free. (Don't underestimate the significance of this: It's a huge gift from the government.) But this might be an easier sell if you explain to your child that he doesn't have to wait roughly four decades to access his summer money.

In contrast, if your child contributes to a Traditional IRA (which offers an upfront tax-deduction on contributions), most or all of the subsequent withdrawals will be taxed. Furthermore, withdrawals before 59 1/2 will be hit with a 10% penalty tax, unless the money is used for certain IRS-approved reasons (one of those reasons is to pay college costs).

Another reason for shunning the Traditional IRA is because your child may not actually be entitled to any tax deductions for his contributions. Why? Because an unmarried dependent child's standard deduction automatically shelters up to $5,700 of earned income for 2009 and 2010. So unless your child's job paid more than $5,700 or he had income from other sources (like dividends and capital gains from a trust or custodial account), contributing to a traditional IRA won't generate any current tax savings.

Finally, the fact that your child owns an IRA (Roth or Traditional) won't cause him or her to lose out on any financial aid benefits at college time. Why? Because the financial aid number crunchers don't count IRAs as assets. In other words, IRAs are invisible when it comes to determining financial aid eligibility.

How I went about setting up a Roth IRA for my seven year old son
After finding out this information and already knowing the Time Value of Money, I wanted to get a Roth IRA set up for my child ASAP! My recently learned knowledge of this information led me to a little “experiment” with my seven year old son that would be a good lesson for him … as well as for me. In the following paragraphs, I will show you the steps I took to document verifiable earned income for my son that allowed me to set up a Roth IRA for him:

1.) The first thing I did was to research how my son would be able to get verifiable income. I read Young Bucks: How to Raise a Future Millionaireby Troy Dunn that gave great suggestions of types of jobs that children can do to make money as well as ways to have your children’s enthusiastic participation in the process. I also read The Kid's ROTH IRA Handbook: Securing Tax-Free Wealth From a Child's First Paycheck or Money Answers for Employed Children, Their Parents, the Self-Employed and Entrepreneursby Tracy Foote that showed simple ways to have the child document their income, as well as how to do their own taxes.

So, based on my research, I also found out that there is no minimum or maximum age limit set on when you can start a business! Starting your own business can help with the documentation, if your child doesn’t get a W-2 with the income that is made. So, we made the decision to start a business for my seven year old son. Here are the steps we took to create the business:
  • The first step for starting a business was to identify the type of business my son would go into. It was decided that we would go down the path identified in The Kid's ROTH IRA Handbook as the Self-Employed Child (we decided to provide a service instead of selling a product because, with selling a product, keeping a sales log that keeps track of materials, profits and losses as well as doing taxes that would require a professional would make things much more difficult -- and not as much fun).
  • The next step was to research for any licensing fees that our state may have. We just went to http://Google.com and searched for “[state] business license”. I found that for a Services business there was no need for a license in Maryland, but for a Sales business you would need a Tax Account License. However, for both Services and Sales you need to register with the Department of Assessment and Taxation. Also, for a nominal fee of $25.00 we could have registered for a Trade Name (the name of the business that you created). We took the easy route by creating a Services business and we didn’t register for a trade name, so all we had to do was register with the Department of Assessment and Taxation for free.

    The registration form asks for your Federal Principal Business Code Number (the type of business that you creating). You can get the full list of these codes in the Schedule C Tax Form's instructions page or at http://www.taxalmanac.org. Here are some examples:
    • Lawn Mowing = 561730 for Selling Landscaping Services
    • Babysitting = 624410 for Child Day Care Services
    • Dog Walking/Cat Feeding = 812910 for Pet Care Services
    • Elderly Assistant = 624100 for Individual & Family Services
    • Retail Selling (crafts, etc.) = 453220 for Gift, Novelty, Souvenir Store

    If your business does several of the above then the business is an “odd jobs” business and the code would be 624100 for Individual & Family Services (assisting families). That’s the one we chose!
  • Finally we sent in the registration form. The address and fax number to send it to were both located on the form. (I would recommend just faxing it in so you can get your unincorporated business number immediately. Using the snail mail could take up to two weeks.) And that is it! Not too painful and now my son was really in business!
2.) After the business was created we then had to figure out what “odd jobs” my son could do to earn some income. (If you get stuck at this point, I would really recommend you reading the Young Bucks book that I mentioned earlier.) We didn’t have to look far considering it was during the record-breaking winter that we go three blizzards in a row! My son was excited to make money for his new business by shoveling snow. Every time my son shoveled snow he would religiously fill out his income sheet, because you need to keep good documentation if you are to have verifiable earned income. Here is an example of the Income Sheet, Expense Sheet and Sales Sheet that I got out of The Kid's ROTH IRA Handbook. (We didn’t need to use the Sales Sheet because we created a service business and we didn’t need to use the Expense Sheet because we had no business expenses at this time.)

3.) Next, with his earnings, I wanted to go to the bank and set up a checking account for my son, because, I wanted him to be able to write the check to get his own Roth IRA. However, I found that you need to be at least 16 years old to get a checking account. So, I got him a savings account where he would store all of his earnings. I let him fill out his own deposit slip and showed him how to balance his register on his next deposits. My son was really excited and proud to be doing this and I found it to be a great father-son bonding time.

4.) Now, that he had earned the income, we wanted to be sure it was verifiable earned income. So, we decided to follow the instructions in The Kid's ROTH IRA Handbook to do the taxes. Why do taxes when he probably didn’t make enough to need to file? Because we wanted to make sure we had good documentation. This was also another great lesson in following instructions and understanding how to fill out tax forms. My son did not need a W-2 because he had his own business and was now self-employed! He only needed a few forms and they were pretty easy to fill out:
  • Form 1040
  • Schedule C: Profit or Loss from Business
  • Schedule SE: Self-Employment Tax
5.) Finally, now that earned income was fully documented and verifiable, we were able to start that Roth IRA that we originally talked about! With the potential of over 50 years of compounding returns, even a modest amount of money in a Roth IRA now can turn into very big tax-free bucks.

During this process I would tell family and friends about my son’s new business enterprise and subsequent plans for setting up a Roth IRA and I would only receive positive remarks and questions on how they could do something like this for their children. I even indirectly got some other work lined up for my son while describing our plans to some family members. My brother-in-law was soon to be getting married and his wife-to-be offered my son a job of placing stamps on the envelopes of their wedding invitations. Hey, now that’s an “odd job”! So, I hope you can see that there are all sorts of opportunities out there.

Overall, this was a very enriching and fulfilling experience for me and my son and I would recommend anyone with a child, grandchild, niece or nephew to go through this or a similar exercise. It is never too soon to start investing for a child’s future. Opening an account early can give them valuable lessons in finance, as well as a head start on saving for retirement. And remember, Roth IRAs are not just for grownups anymore!

I'm so excited to share this information with you. If you have enjoyed the information or feel that it would benefit someone else, please share it. If you have any questions or comments, please feel free to contact me.
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