CONTRIBUTING TO A CHILD’s IRA by Karla Hopkins

Establishing an IRA in a child’s name can be an effective planning technique for a child with earned income. The annual limit cannot exceed the lesser of $5,000 or the earned income.

The key to contributing to an IRA is that the child actually earned income. This can include income from a part-time job, summer jobs, babysitting, lawn mowing or paper routes. Where you may not have reported the income in the past, you may elect to so that the child is eligible for an IRA. When a child is employed by a family member, the IRS can be expected to scrutinize carefully whether the income was in fact earned, and a reasonable hourly rate must be used for the work actually performed.

Parents often get frustrated when even a small amount of their child’s income is subject to tax. This occurs because of several things like the disallowance of the personal exemption, reduced standard deduction, higher interest and dividend income from savings accounts.

Under the Kiddie Tax rules, dependent’s investment income is taxed at the parent’s higher tax rate. (if the investment income exceeds $1,900) One way to shelter investment income of a dependent is by contributing to a deductible IRA. Because a deductible IRA is a pretax earnings account, the benefit of compounding investment income is a significant retirement benefit for the dependent.

Establishing and funding a ROTH IRA, which is a nondeductible contribution, can also be a significant retirement and long term tax favored savings strategy for a dependent. Contributions to a ROTH IRA are not deductible but if certain conditions exist, distributions are tax free.

Even though the contributions to a ROTH IRA are not deductible, this may be considered a small price to pay (i.e. the tax on the dependent’s investment income) for the power of tax free compounded earnings inside the ROTH IRA combined with the ability to withdraw funds tax free upon retirement or after age 59 1/2.

Also, if the ROTH IRA has been established for at least five years, the contribution amounts can be withdrawn tax free any time after the five year window which could be an advantageous college funding plan. The contribution does not necessarily have to come from the child’s earnings. As parents, you could gift the additional money for the IRA so that the child continues to keep his spending money. The long term savings available from this type of arrangement is highly recommended.