Opening a kid's Roth IRA

[retire@40]

No one ever seems to withhold income tax from wages paid to children for chores.  Common sense (is there such a thing?) tells us that it really isn't taxable income.  Therefore, the IRS could argue that either (1) it isn't income so no Roth contribution is allowed or (2) it is income, so where is your withholding, w-4 and w-2?
 
So I would guess there is a risk here.  You might have a W-4 filed out, saying "exempt" (though I am not sure the income is exempt from withholding in the first year of employment) and issue a W2 showing no withholding.

Why are you so caught up with the withholding thing?  Who said you have to have withholdings on W-2 income?

 

[Martha]

I'm not so caught up in the withholding because the kid shouldn't have to pay taxes anyway and might not even need to file a return. The issue I raised is whether income from household chores supports a Roth IRA and that is what I think might be a gray area.

 

[retire@40]

The issue I raised is whether income from household chores supports a Roth IRA and that is what I think might be a gray area. 

Money given to your child for performing houshold chores is considered a gift and does not qualify as earned income and therefore can not be considered for any retirement plan for the child.

 

[Nords]

Money given to your child for performing houshold chores is considered a gift and does not qualify as earned income and therefore can not be considered for any retirement plan for the child.

And your specific reference for that would be...?

 

[retire@40]

And your specific reference for that would be...?

It's called the smell test.

If you are prepared to make a case that you as the parent are the employer and your child is the employee, you better be ready to answer how you arrived at amount of compensation paid, documented by time sheets, quarterly payroll tax returns including year-end summaries, and all the other requirements of an employer.

You may also want to be prepared to explain any birthday and Christmas "gifts" that you gave your "employee" that could now be considered diguised compensation along with all the other benefits that were "given" to your employee that were not properly documented.

By the way, if your next  door neighbor pays the exact same amount to his child who is the same age as your child for the exact same work, is he committing fraud because he didn't file all his payroll reports?

Payment for household chores is NOT earned income for your child!

 

[Martha]

I did a quick check (so I might have missed something) but I see no revenue rulings or pubs on the issue of "chores". How about this for an argument. If the chore is something people often hire others to do, money from it is earned income. If the chore is something people rarely are hired for, then it is not earned income. For example, mowing lawn=earned income. Setting the table=not.


Just a thought. No one wants to be the test case.

 

[Martha]

Here is the pub on when withholding is required. Note the kid might be exempt from withholding if no tax paid prior year and no unearned income. If unearned income, such as interest income, you will have to withhold income taxes for work in a family business. http://www.irs.gov/pub/irs-pdf/p505.pdf

 

[retire@40]

I did a quick check (so I might have missed something) but I see no revenue rulings or pubs on the issue of "chores".  How about this for an argument.  If the chore is something people often hire others to do, money from it is earned income.  If the chore is something people rarely are hired for, then it is not earned income.  For example, mowing lawn=earned income.  Setting the table=not.

Just a thought.  No one wants to be the test case. 

The only way paying your child as an employee will work is if you have a business and he or she is doing real work in your business.  The business has to be real and must have a profit motive.  You must file a schedule C or other business tax return, and the work done by your child must actually be performed, and reasonable compensation for that work must be paid.

If you want to set up a legitimate landscaping business and pay your child as an employee for mowing the lawn, that would work.

 

[cute fuzzy bunny]

Our resident lawyer just said there are no pertinent rulings or documents for this.

Is this your opinion or is there some factual basis for the statement?

 

[retire@40]

If unearned income, such as interest income, you will have to withhold income  taxes for work in a family business.

What does unearned income have to do with any withholdings on earned income from a family business?  If the child makes $100 in interest income and gets a W-2 with $100 gross income from a family business, there need not be any withholdings.

You only need to withhold when certain income threshholds are met.

 

[KB]

My oldest son earned money from babysitting and mowing lawns, splitting wood and other odd jobs for other people. And that money was used to open his Roth IRA. Not from any work he did for me. So where does that fit in relation to this thread?

 

[Martha]

What does unearned income have to do with any withholdings on earned income from a family business? If the child makes $100 in interest income and gets a W-2 with $100 gross income from a family business, there need not be any withholdings.

You only need to withhold when certain income threshholds are met.

I was too definate about saying any unearned income, but it does take very little unearned income to make it so that you are not in the position of being able to claim an exemption from withholding. Read pub 505, the link is above. Look at worksheet 1.4.

 

[Martha]

The only way paying your child as an employee will work is if you have a business and he or she is doing real work in your business. The business has to be real and must have a profit motive. You must file a schedule C or other business tax return, and the work done by your child must actually be performed, and reasonable compensation for that work must be paid.

If you want to set up a legitimate landscaping business and pay your child as an employee for mowing the lawn, that would work.

Since there are no rulings on this issue, I will give you a counterargument. You know that the basic theory of the IRC is that income from all sources is taxable, unless there is a specific exemption. Therefore, to be technical, if you hire your 13 year old daughter to mow the lawn and pay your child, the income is subject to tax. Doesn't matter if you have a bona fide business or not. The tax code only cares about income. Now everyone believes this really isn't true, even though the tax code literally would make it true.

Now only bona fide businesses get to deduct the wages paid to the child. Because you don't have a business, mom and dad can't deduct the wages paid.

The next issue is whether the money paid is "compensation" for the purposes of a Roth IRA. This publication defines compensation: http://www.irs.gov/pub/irs-pdf/p590.pdf
See page 7. It includes earnings from self employment (the child arguably is self employed in mowing lawns and doing chores), and includes wages. This child was paid for work. Sounds like a wage to me. However, if the child excludes the money from her income, then it is not compensation. That is why you would need to be sure to follow all the IRS rules on tax reporting and determining if there is an exemption from withholding.

Now of course, this is only an argument.

I did say that you would not want to be a test case.

 

[Martha]

My oldest son earned money from babysitting and mowing lawns, splitting wood and other odd jobs for other people. And that money was used to open his Roth IRA. Not from any work he did for me. So where does that fit in relation to this thread?

The Roth sounds ok to me in this case--see my prior post. Not thinking about what type of tax returns he has to file though.

 

[retire@40]

It includes earnings from self employment (the child arguably is self employed in mowing lawns and doing chores), and includes wages...I did say that you would not want to be a test case.

You are contradicting your own arguement.  If you say the child is self-employed, then how is he supposed to get a W-2 from his parents?

But you are correct that nobody would want to be a test case since they would lose this case.  And that loss would amount to 6% per year as long as that money sits in he Roth IRA.  Good luck to all you non-business owners that may be doing this.  It only works until you get caught.

 

[Mr._johngalt]

You are contradicting your own arguement.  If you say the child is self-employed, then how is he supposed to get a W-2 from his parents?

But you are correct that nobody would want to be a test case since they would lose this case.  And that loss would amount to 6% per year as long as that money sits in he Roth IRA.  Good luck to all you non-business owners that may be doing this.  It only works until you get caught.

I kind of agree, but you are a little argumentative. I am sure
Martha knows the difference. She just stated it poorly. Happens to all of us.

JG

 

[retire@40]

Our resident lawyer just said there are no pertinent rulings or documents for this.

Is this your opinion or is there some factual basis for the statement?

Frankly, I am perplexed why there would not be a ruling regarding wages paid for family chores.  However, since the IRS has ruled against taxpayers based on the "smell test" even though there may not have been a reg or ruling in those cases, this scenario falls within those same "smell test" parameters.  Remember, the IRS looks at substance over form.  Just because you may prepare a W-2 for your kid, it doesn't necessarily mean it's a valid W-2 form.

Unless someone can point to a case that shows a taxpayer beating the IRS on this issue, I would not recommend you try this at home.

 

[retire@40]

My oldest son earned money from babysitting and mowing lawns, splitting wood and other odd jobs for other people.  And that money was used to open his Roth IRA.  Not from any work he did for me.  So where does that fit in relation to this thread? 

Perfectly fine.  He was an independent contractor with earned income and can contribute to a Roth IRA if he's not disqualified for some other reason.

 

[retire@40]

I kind of agree, but you are a little argumentative.  I am sure
Martha knows the difference.  She just stated it poorly.  Happens to all of us.

But if you make a statement to the IRS like that, you just lost the case. 

Lawyers live and die by their words, just like politicians.  Look at what happened to Kerry when he said he voted against something after he voted for it.

I will shake hands with Martha when we are all done with this point counter-point, but until then, I have my gloves up and boxing.

 

[KB]

Thanks all. Whew. that was tough......

 

[ESRBob]

Kiplingers sides with Retire@40 in their recent article on the subject -- chores don't cut it. If you don't have a business, put the kid to work for other people -- it's even cheaper for you!

And since they are forking all their money over to this Roth thingy, then give them a nice big allowance.

Kiplingers talks about a matching funds agreement where the kid just earns the 4k+ per year, spends it or saves it in the Roth in some proportion as you agree, and you just make up the balance with a gift/check into the Roth. Where the actual Roth check comes form doesn't matter, just that the kid had earned income in sufficient quantity.

One more reason to have a profitable little self-employment gig on the side. Then having your kid maintain your home/home business' wireless network, keep the computers free of spyware, upgrade operating system and so forth, and keep the company's website up to snuff are all good training and valid stuff you'd need to pay for anyway. And improve their odds of finding work in the community next year. (At least that's my plan).

 

[Martha]

ERS Bob, I agree, I wouldn't do it another way. I didn't suggest the idea that paid for chores constitute employment, someone else did. I said the area is gray because there is no ruling on the issue. I did try to throw out some arguments in favor of treating compensation for chores as compensation supporting an IRA. But I really do think it would be a long shot. And Retire@40 is right that just because there is no ruling doesn't mean you will get out of penalties and interest when the IRS doesn't buy your argument.

 

[Martha]

You are contradicting your own arguement. If you say the child is self-employed, then how is he supposed to get a W-2 from his parents?

But you are correct that nobody would want to be a test case since they would lose this case. And that loss would amount to 6% per year as long as that money sits in he Roth IRA. Good luck to all you non-business owners that may be doing this. It only works until you get caught.

I did not contradict my own argument. I gave some of the definitions of compensation from the applicable IRS pub. You can be paid a wage. You can be self employed. Etc. KBs kid is clearly self employed. Of course different tax forms are required depending on whether you are an employee or self employed. Part of the problem with going through analysis of issues on a message board such as this is that you cannot write a comprehensive memorandum of all issues in one post. The particular issue discussed at that point was "what is the meaning of compensation in the context of an IRA", not what tax forms need to be filed, which depends on how you characterize that compensation. I simply emphasized that for the argument to work, you better file the appropriate tax forms. Of course, determining if the child is exempt from withholding is only relevant if you consider the pay a wage.

But if I was not clear enough in my prior posts, I would not recommend treating paid for chores at home as compensation to support a Roth IRA. However, I don't buy your argument about business purposes. To me, that argument is only important in the context of deductions. [edit: for example, you have to pay the nanny taxes even though you don't have a business, you just can't deduct what you pay in income taxes] However, I agree with you that the family likely would lose before the IRS. The basic problem is that people don't in fact treat payment for chores as earned income. And if it is not treated by you as income, it doesn't meet the definition of compensation I linked to earlier in this thread.

Just before I posted this message, I did a little googling on the issue. I generally avoid that for tax issues and stick to what the IRS says and courts say. For sure I don't recommend taking advise over the internet on these kind of issues. (mine, retire@40's or anyone elses) However, there actually were a few websites that talked about the issue. The two I looked at said it was a gray area. None of the sites I saw went into it as deeply as we have here today. Ain't we great.

arrrr.

 

[cute fuzzy bunny]

Frankly, I am perplexed why there would not be a ruling regarding wages paid for family chores. However, since the IRS has ruled against taxpayers based on the "smell test" even though there may not have been a reg or ruling in those cases, this scenario falls within those same "smell test" parameters. Remember, the IRS looks at substance over form. Just because you may prepare a W-2 for your kid, it doesn't necessarily mean it's a valid W-2 form.

Unless someone can point to a case that shows a taxpayer beating the IRS on this issue, I would not recommend you try this at home.

Ok, I got it. Opinion stated as fact. Thanks.

So lets look at this in a prarie dog fashion. You open the roth, the kid funds it with money you give them for doing stuff in the faux 'family business' or for chores or through schedule 29c subsection d paragraph 12...whatever. No tax return is filed because income is below the threshold as already discussed. Life goes on...

What exactly would trigger an audit or other activity where the IRS would even get engaged to decide what you did was wrong? Does the investment company send any kind of paperwork to the IRS stating that a roth was created/funded?

 

[retire@40]

Ok, I got it.  Opinion stated as fact.  Thanks.

What exactly would trigger an audit or other activity where the IRS would even get engaged to decide what you did was wrong?  Does the investment company send any kind of paperwork to the IRS stating that a roth was created/funded?

First, if you think it's not a fact that the IRS uses the "smell test" to scrutinize financial transactions, I can tell you haven't been involved in many IRS issues.  Good for you for staying out of trouble.

Paperwork = Form 5498 sent to IRS and IRA owner.