There's no minimum (or maximum) age to set up a Roth IRA. And there's no requirement that the same dollars that were earned be used to fund the IRA. If your child earned money on a summer job and spent it on whatever kids spend money on these days,* there's nothing wrong with using money provided by parents to establish the IRA. The child has to have earned income, though.

 

Tax-free compounding of earnings inside an IRA is a beautiful idea — and a powerful one. The longer you can keep your money invested in a tax-free vehicle, the greater your wealth accumulation. What better way to accumulate a large amount of savings than to start during childhood? When tax-free compounding has more than 50 years to run its course, a relatively modest savings plan can produce substantial wealth.

 

 

Example 1: Johnny, age 13, has a part-time paper route and earns $1,400 per year. His parents open a custodial Roth IRA for Johnny and fund it through gifts limited to the amount of his earned income each year. If Johnny keeps the paper route until age 18 (five years of funding), continues to earn $1,400 per year and never puts another dime into the Roth IRA, it will grow to $305,787 by the time he turns age 65 (assuming an eight percent average annual rate of return). Not bad for a total investment of only $7,000!

 

Example 2: Sarah, age 15, works for her mother, a real estate agent. She helps her mother with data entry and promotional flyers. Her mother can pay her what she would reasonably pay an outside employee for the same duties (say, $15 per hour). Sarah works 300 hours each year until age 18, earning $4,500 per year. Sarah contributes $2,000 to a custodial Roth IRA and her mother matches that with a $2,000 gift for a total of $4,000 per year. In four years, she will accumulate $18,024 in her Roth IRA (assuming an eight percent average annual rate of return). If Sarah continues to work for her mother through college (an additional four years) and make additional contributions, the account will grow to $42,546. If she stops and lets the money grow tax-free until age 65, she will have amassed $1,164,341. If she continues to contribute $4,000 per year after college until age 65, she will have a whopping $2,482,673 - all available tax-free!

 

 

There is one drawback. The money in your child's IRA belongs to the child. There's no way to restrict the child from withdrawing it and using it in any way he or she chooses, at least after the child reaches the age of majority. Bear this in mind before you pour many thousands of dollars into an IRA for your child.

 

First, remember that the money must come from legitimate earned income, so it will be difficult for a very young child to qualify unless he or she is a child actor or model. The income has to be compensation income, not investment income. And it has to be taxable compensation income.

That doesn't mean your child has to actually pay tax on the income. If the total amount of income is small enough so your child doesn't have to pay tax, that's okay. But your child has to have the kind of income that would call for a tax payment if the amount were large enough.

 

Example: Your child earns $2,350 bagging groceries after school and during the summer. No tax is due on this amount — the only reason to file an income tax return is to get a refund of any withholding. But your child can contribute to an IRA because the earnings are taxable compensation income.

 

 

What if the parent is the employer? The fact that the income comes from a parent doesn't disqualify it, although the IRS may take a closer look in cases like this.

 

There have been a number of court decisions dealing with parents who paid children to work in the parent's business. None of them deal with the Roth IRA, though. These cases generally deal with the parent's deduction for the amount paid to the child. The Tax Court has allowed the deduction when it was convinced that the parents paid fair compensation for work actually performed in a real business. When the compensation wasn't a reasonable payment for work actually performed or didn't relate to a business, the deduction wasn't allowed. Bogus compensation won't support a contribution to a Roth IRA, either.

 

 

Why not use a child's earnings from household chores to meet the earned income requirement? Let's make some favorable assumptions:

·         The child is actually doing work for the money.

·         You're paying only a reasonable hourly rate for the work.

·         You have good records to prove that the work was done and the money paid.

Will that do the trick? Strangely enough, there's no clear guidance on this issue, but the answer seems clear enough to me. Payments to family members for household chores are not taxable income, so they can't be used to support contributions to IRAs.

 

It's difficult to prove this income isn't taxable. The Internal Revenue Code says all income is taxable unless an exception is made, and there's no exception for amounts paid by parents to family members for household chores. Yet this is one of those things we all know instinctively. No one ever reports this kind of income on a tax return, and no one thinks they're cheating when they fail to do so. The IRS has never suggested that this income should be reported. Just imagine the uproar if the IRS tried to collect tax on the money parents pay their children to babysit younger siblings or mow the lawn.

 

There's little chance the IRS will actually challenge IRS contributions based on income from household chores, at least if you keep the contributions within the limit of amounts actually paid as reasonable compensation for work actually performed. But that doesn't mean these contributions are legal and proper.