The Child Self-Directed Roth IRA Strategy is incredibly powerful. When properly implemented, it will provide incredible investment returns and drastically lower your tax bill.
When is a Roth IRA the way to invest? Roth vs. Traditional IRA
Roth IRAs allow for totally tax-free growth, as opposed to Traditional IRAs that are only tax deferred but benefit from an upfront tax deduction. Assessing whether to use a Roth IRA versus a Traditional IRA requires an analysis of the value of an upfront tax deduction of the Traditional IRA, as opposed to the value of tax free earnings.
- The greater the projected investment earnings the more appealing the Roth option.
- The lower the investor’s current income tax rate the greater the appeal of a Roth contribution.
- The lower the investor’s projected future tax-rate – at IRA distribution – the greater the appeal of the Traditional IRA.
Self-Directed Roth IRAs For Children
For children, who have (a) little or no income tax to pay – effectively a 0% current effective income tax rate, (b) will certainly be in a higher income tax bracket at withdrawal than their current tax bracket, and (c) an additional 20 years of investment compounding growth, a Roth IRA is an incredibly powerful vehicle. A no-brainer, really!
Although it may seem that there are many obstacles to implementing this strategy, read on to see how doable it is and that the benefits are greater than you could possibly imagine!
What should you consider before opening a Roth IRA For Your Child?
- Earned Income
- FICA, FUTA, SUTA
- Dependency Exemption
- Standard Deduction
- Kiddie Tax
- College Financial Aid/FAFSA
- Roth IRA
- Passive Income
- Portfolio Income
- Roth IRA contribution limits
- Income Shifting
- Self-directed IRA
- Solo 401(k)
- Gift tax/Transfer Tax
- Payroll processing
- Workman’s comp
The good news is that when “employing” your children that are under 18 year of age, much of the compliance issues associated with having employees don’t apply!
Roth IRA Contributions: Earned Income vs. Passive Income
We won’t get into too much detail in this post so as not to overburden anyone (including us), but the key is to understand that IRA contributions can only be made by those that have earned income – and paying children to do household chores does not qualify. So the first step to making Roth IRA contributions for your child is to get them some earned income, either by having them assist you in your business (assuming you have one) or having them do work for someone else.
Earned income, as opposed to passive income and portfolio income, is generated when the earners material participation results in income – whether that be self-employment income or W-2 wages.
Do You Have to Withhold and Pay Payroll Taxes On Your Child’s Income?
The presence of child earned income raises the following question:
- Do FICA, FUTA, SUTA, and income tax have to be withheld from the child’s earnings?
- Is Workers’ Compensation insurance required?
- Is a payroll processing company required?
- Will my child have to pay income taxes and file an income tax return?
- Will we be paying tax prep fees?
- Will I lose the ability to claim them as dependents on my income tax return?
If you’ve got a business and it’s not an S-corp or C-corp, the amazing news is that you can pay your children and NOT withhold any taxes.
How Much Can You Pay Your Children?
Any payments must be reasonable – don’t pay them $5,500 for shredding a few sheets of paper. They must actually do work for your business, which can be paper-shredding, cleaning, or something that they excel at – assisting with social media marketing, such as Facebook, Twitter, Reddit, and Instagram.
Will Your Children Have to File and Pay Income Taxes?
Children are entitled to the standard deduction, so no income tax liability on up to $6,300 of income for 2017 – $12,000 for 2018. Beyond that, you may benefit from a Solo 401k.
Will You Still Get a Dependency Exemption on Your Tax Return?
You’ll still get to claim them as dependents on your tax return for 2017, unless they provide most of their own financial support. Not likely (wishful thinking). For 2018, Tax Reform eliminated dependency and personal exemptions.
How Powerful Is the Child Roth IRA Strategy?
As you may be able to intuit, there are some incredible tax opportunities available. Some absolutely astounding planning options, which can only be touched upon here. By following the steps below, you can effectively get a business tax write-off for expenses that would otherwise be treated as personal.
- Get a business.
- Get your kids involved.
- Pay them a reasonable wage for services performed.
- Get a BUSINESS TAX DEDUCTION for paying your child, which would be an ordinary and necessary business expense.
- Have your children pay for some of their needs and wants, which you would have otherwise paid for with after-tax funds – from their tax-deductible earnings.
- Make Roth IRA contribution on their behalf, up to the lower of (a) the amount of their earned income and (b) the Roth IRA contribution limits.
A powerful strategy to consider is forming a Self-Directed Roth IRA for your children, or a Roth IRA-LLC, which can invest in real estate and many other assets.
An important compliance note: document everything so that your IRS audit proof. As you can see, while these are legitimate strategies, they are ripe for abuse.