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Child Roth 9/10/14

Your Children's Tax-Free, Million-Dollar Retirement Accounts

Click to see the math that justifies the statement

 

If you run a business or a professional practice, you should consider hiring your children or grandchildren. The younger they are, the better. You’ll not only cut your own taxes today, but it is more than likely that the child will end up with a multi-million-dollar retirement fund, decades from now.


The premise is simple. Money you pay the youngsters reduces your own income and your income taxes. The children will owe little or no tax, which you can pay for him or her, while fully funding their Roth IRAs.


That’s right, anyone with earned income can have a Roth IRA even a child.


Under current law, qualified Roth IRA distributions aren’t taxed, no matter how much income is reported on the owner’s tax return. Unlike traditional IRAs, where distributions are taxed at the prevailing rates, Roth distributions are not taxed at all (after age 59-1/2, as long as the account has been open for more than five years). The total value of the account will be theirs to use, regardless of how high tax rates might be in the future.

 

Crunching the numbers


To put a face on this hypothetical exercise, suppose that you hire your young daughter to work for your company. If she earns at least $5,500 a year, that much could be invested in her Roth IRA. (You could pay her more in order to cover any payroll taxes.). If she works for your business for 10 years and after that, your business makes no further payments to her, your business would have paid her enough to have allowed her to contribute $55,000 to her Roth IRA.


How much that investment would be worth at the end of those 10 years depends on the rate of return her investments provided during that period. To get an idea, we built models to calculate returns of 6%, 8%, and 10%, which represent a relatively conservative range of possibilities. Are these returns realistic? Morningstar’s Ibbotson subsidiary tracks investment returns going back to 1926. Through 2013, large-company stocks returned 10.1% a year while small-company stocks returned 12.3% a year.


Using our three models, we figured that the $55,000 total invested in your daughter's Roth IRA would be worth $74,669 at the end of 10 years at 6%, $82,863 at 8%, or $92,039 at 10%. Keep in mind that the full $55,000 was not invested for the full 10 years. In fact, it was invested, on average, for only half the time. But the compounding is just beginning!


Let’s say that your daughter earns 8% a year inside her Roth IRA, doubling every nine years (using the Rule of 72). Her initial $55,000 ($5,500 invested every year for 10 years) would be worth about $3,831,415 after another 50 years. And if she earned 10% per year, that figure would be $10,749,493. That’s the power of compounding!


Again, how reasonable are these calculations? The mutual fund we started for our subscribers is made up of high-quality dividend-paying stocks that offer Direct Investing Plans, or DRIPs. Even during the past 10 years, which included “the Great Recession,” the fund has provided an annualized gain of 7.81%. The return for the past one-year period was more than 21%. So it's not unrealistic to expect a well-run, conservative mutual fund such as DRIPX to provide a 10% annual return over a lifetime.


Keep in mind that those astounding results are based on the child contributing nothing beyond the 10 years that you employed her, so if your child contributes anything to the account later on, the tax-free Roth IRA buildup is likely to be even more overwhelming.


On the job


Still, many assumptions underlie those accumulations. To begin with, what kind of work can a young child do to earn $5,500 or more? The IRS might be skeptical.


The answer is: Lots of things. Chances are that your business has a website and various promotional brochures. If a family theme fits in, you can use young children as models and pay them the going rate. My grandson, now age 8, has been brightening our company’s website and promotions for five years and has a good start on his Roth IRA. What’s more, such pictures on your website or brochures will help illustrate your benefits and are likely to help your business.


As your children grow older, the range of possible employment opportunities will expand, inside and out of the office. Besides the tasks that first come to mind (filing, cleaning, grounds keeping), your teenager (or pre-teen!) might help you establish a social media presence or do market research among peers.


You could even buy a house near campus so your live-away collegian can avoid dorm fees while earning a management fee if you rent rooms to other students. (Your real estate ownership might not be part of your business, but your child could still be working for you, doing market research, etc.)


Tax trimmers


As mentioned earlier, hiring your child or grandchild can have immediate tax advantages for your family. Say you have an effective 35% marginal tax rate and you pay your child $5,500 a year. You save $1,925 a year: 35% times $5,500.


Your child can earn up to $6,200 in 2014 (the standard deduction amount) and avoid income tax. Up to $5,500 of earnings can go into a Roth IRA this year, for people under age 50. Both of those numbers increase periodically, to keep pace with inflation.


Payroll tax can reduce some of the benefits of this strategy. However, true family businesses enjoy some tax advantages.


For instance, wages paid to a child under age 18 who works for his or her parent’s trade or business are not subject to Social Security and Medicare taxes, as long as the entity is a sole proprietorship or a partnership between the child’s parents. In addition, wages paid to a child under age 21 who works at a parent’s trade or business are not subject to federal unemployment tax.


More than money


Court cases have upheld deductions for wages paid to very young children, provided the parents could show they worked for the family business and received fair compensation. And hiring your children can deliver more than tax savings and a substantial Roth IRA. At an early age, your youngsters can get an idea of what it means to work for money. They can learn values such as being on time, cooperating with other employees, and taking pride in accomplishing the tasks that they’ve been asked to perform.


Such beyond-school education might be largely lost on your three-year-old, but it won’t be long before your children are getting more from the entire exercise than just a Roth IRA.


Indeed, at some point you can begin to discuss investing with your child. It will be his or her retirement fund, so your child should have some idea of how the money is being invested and why. Helping your children to become intelligent investors can be at least as worthwhile as the money you’ll ultimately spend to send them to college!