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Roth IRAs and Your Kids 05/12/17

Roth IRAs and Your Kids


    I have written often on the effects of compounding over the long term, emphasizing the simple but potent message that the sooner you start, the more the multiplying effect you will experience in your investments. Over a truly long period, say 40 years, the effect is almost unbelievable. That’s why it makes so much sense to help your children take advantage of the benefits of compounding—particularly within a Roth IRA where taxes won’t diminish the results each year.

     

    Under current law, qualified Roth IRA distributions are not taxed, no matter how much income is reported on the taxpayer’s tax return. Anyone with earned income can have a Roth IRA, even a child. You might consider hiring your children or grandchildren to do work around the house, or, if you run a business or a professional practice, you can hire them there. The younger the kids are, the better. You’ll not only cut your own taxes today, but you’ll set the kid on a path that could lead to a multi-million-dollar retirement fund decades down the road.

     

    The premise is simple. Money you pay the youngsters reduces your business income and thereby 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.

     

    Miracle of Compounding Creates Multi-Million Dollar Wealth

     

    If your child or grandchild works for your business for 10 years and your business pays him $5,500 a year and makes no further payments to him after that, he would have contributed $55,000 to his Roth IRA. How much would it be worth 40 years later? The $55,000 investment would have grown over the ten-year period depending on the rate of return.

     

    But let’s be very conservative and base our assumption on a $55,000 investment growing on an average annual rate of 7% over a 40-year period. It would be worth $1,140,035.42. The actual long-term average annualize rate of return of the market as whole is more like 10%. What would the $55,000 investment be worth at that rate over the 40-year period? An astounding $2,489,459.

     

    What kind of work can a young child do to earn $5,500? The IRS might be skeptical. The answer is: Lots of things. There’s no reason why you can’t hire your child to do work around your house and lawn or work around your office. If you run your own business, chances are that your business has a website and produces various promotional brochures. If a family theme fits in, you can use young children as models and pay them the going rate. Such pictures on your website or promotional brochures can help illustrate the benefits of your business to potential customers.

     

    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. When the child is off to college, you might 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.

     

    Tax Advantages for the Entire Family

     

    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.

     

    There are other tax advantages for hiring your children. 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. Court cases have upheld deductions for wages paid to very young children, provided the parents could show they were paid fair compensation.

     

    And hiring your children can deliver more than tax savings for you and substantial long-term wealth for your child. 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. 

     

    That brings me to another important consideration: Unlike assets held directly in his or her name, assets held in a retirement account will not affect your child’s ability to obtain financial assistance to pay for college (even though some withdrawals from a Roth IRA can be made without penalty to pay for secondary education). The same process can be established using no-fee DRIPs. The effect of compounding will be the same, but the dividends thrown off by the companies will be taxable annually at the child’s rate and eventually the gains will be taxed at favorable rates.

     

    The advantage of compounding wealth in this manner through DRIP accounts is that the youngster can participate in the adventure. He or she can become involved in the investing process by continually buying shares or fractions of shares by adding even small amounts that are earned over the years. Also, keep in mind that the assets that are accumulating may come in handy very handy when those college tuition bills become a factor.