Opening a kid's Roth IRA

[cute fuzzy bunny]

You're still expressing an opinion. I dont mean to be argumentative (ok, I do) but I like to make sure I know when someones giving me facts or what they think will happen. Its pretty cool when they know the difference too.

I've actually had plenty of experience with the IRS. Its pretty hard to do your own taxes on over a million a year in income with stock options, bonuses, real estate transactions and a stack of investment buy/sell sheets that comes up to your knees and not run into any gray areas. So far everything they've questioned or wanted more info on was satisfied with no additional tax or penalties. And I'm not writing this from the penitentiary

I'm unaware of any official or unofficial 'smell test'. If there is tax law on the matter then there is a guideline. If the tax law is vague, they may make a judgement one way or another, which may be overturned on appeals. If there is no law, then some has to be made before I can be pressed to do anything different, pay any monies, or get in any kind of trouble.

But if theres a 'smell test', paying my kid to do work I might pay someone else to do instead, and letting them invest that payment in a retirement account smells pretty darn ok to me. That there is no specific tax law or precedent saying that paying your kid isnt income says that the IRS doesnt feel the need to have such a law because it'd probably get tossed out the first time it was challenged.

It'd also have to be a pretty slow day at the IRS to have them take the 5498 form, see that there is no matching return, see that its a 15 year old kid, and feel like its a good day to write a letter and find out whats going on.

But I'd keep a quick log of what work was done and how much I paid for the work, to show it wasnt simple chores like cleaning their room, or a simple allowance.

 

[laurence]

My Dad's a recently retired IRS auditor, I'll ask him tonight at dinner about this.

 

[retire@40]

What exactly would trigger an audit or other activity where the IRS would even get engaged to decide what you did was wrong?

Oops, I missed that question with my last response.  Trigger?  How about the parent or the kid bragging to a jealous friend, neighbor, or relative about that scheme.  There could be a nice reward by the IRS for information like that. 

Let's see...a contribution of $4K a year plus interest for 10 years with an excise tax penalty of 6% per year...

 

[Mr._johngalt]

Oops, I missed that question with my last response.  Trigger?  How about the parent or the kid bragging to a jealous friend, neighbor, or relative about that scheme.  There could be a nice reward by the IRS for information like that. 

Let's see...a contribution of $4K a year plus interest for 10 years with an excise tax penalty of 6% per year...

There are a bunch of ways to achieve your goal without doing anything illegal. And, even if you did cross some indistinct line, I doubt the IRS
has the manpower or inclination to knock on your door. Disclaimer:
This should not be construed to suggest bending any rules. Certainly the IRS
is one agency you want to stay on good terms with.

JG

 

[Martha]

Well, I was going to quit poking at this thread, but. . . It often is very hard to know where lines might be drawn on tax issues. Say your teenage daughter mows the neighbor's lawn, gets paid. Mows grandpa's lawn. Gets paid. Runs some errands for grandpa and gets paid. Mows moms and dads lawn and gets paid. Isn't it at least arguable that all this work could support an IRA contribution?

BTW, I did get the highest grade in my law school class in tax law. Of course, it was pre 1986 so basically irrelevant.

I still enjoy reading Bitker and Eustice (or as students say, Bitter and Useless) on tax law.

 

[laurence]

My Dad says people employ their kids all the time, the job has to be something you would otherwise hire someone else to do - but he admits the IRS has a hard time proving that one way or the other. He says if you keep good records, pay stubs etc. and go through the motions of a professional employer/employee relationship, you won't have problems. The red flags would go up when people would say, "well, I uh, would just pay him out of the drawer, er, I think it was that much, job description? eh, er."

But even if they really felt you were scamming, in a case like this they most often come back and with an offer of a civil penalty, late fees etc., you write the check, and you mind your p's and q's for a few years, and you fall off the red flag list.

He did mention that this type of "anomoly" does usually lead to a check of all adult family members to see if there is a pattern in their tax returns. His example was "gee, the guy we slapped down has resonable numbers this year, but all his brothers and sisters have ten thousand dollar losses in their Amway businesses again!"

This activity is not sufficient to trigger an audit on it's own, in his opinion. But hey, he's just one auditor!

 

[retire@40]

Say your teenage daughter mows the neighbor's lawn, gets paid.  Mows grandpa's lawn.  Gets paid.  Runs some errands for grandpa and gets paid.  Mows moms and dads lawn and gets paid.  Isn't it at least arguable that all this work could support an IRA contribution?

This is diverting from the original issue of W-2 for chores and has totally different tax ramifications, but yes, because the child is self-employed in the business of mowing lawns.  The child may file a Schedule C and report all income and related expenses.  But the child will be subject to federal, state, and self-employment taxes.  Whatever is left over may be contributed to a Roth IRA up to $4K.

 

[retire@40]

My Dad says people employ their kids all the time

People employ their kids all the time through their business (not through their household for chores).  That's the key distinction.

 

[Martha]

My Dad says people employ their kids all the time, the job has to be something you would otherwise hire someone else to do - but he admits the IRS has a hard time proving that one way or the other. He says if you keep good records, pay stubs etc. and go through the motions of a professional employer/employee relationship, you won't have problems. . . .

Interesting to have his point of view. Fits with my first "argument" that chores like mowing the lawn, which you might pay someone to do, might be ok, but chores like making your bed wouldn't be fine.

Still better do my cya and say that I wouldn't advise basing an IRA contribution on home chores. I probably would be ok with my prior example of the self employed child who does the same type of work for you as well as third parties

 

[Martha]

People employ their kids all the time through their business (not through their household for chores). That's the key distinction.

I still disagree that this is the key distinction. The relevant question is whether the child is earning compensation as defined by the IRS.

As I stated earlier, people pay compensation to others without having a business. The example I gave was paying the nanny and being liable for the nanny tax. No business involved. This only means you can't deduct business expenses. It has nothing to do with whether the child or the nanny gets compensation as defined by the IRS.

 

[laurence]

Yes, definitely, through a business, or as their own business. Have at least a semblance of legitimacy-Martha I think your example is correct, too, but didn't ask Dad specifically. But even if you don't, you probably won't get caught. He put it like this, medium reward, small risk, huge penalty if you do get caught. Is it worth the risk? (we put aside ethical judgements even though we both had opinions in that realm).

 

[Martha]

This is diverting from the original issue of W-2 for chores and has totally different tax ramifications, but yes, because the child is self-employed in the business of mowing lawns.

Since we are arguing here, the original question wasn't about W-2s for chores, but about Roth IRAs.

But it is important to know that you do have to do an analysis to figure out whether the child is self employed in her business or whether the child is getting a wage and is an employee because totally different reporting is required as you well know.

 

[retire@40]

Since we are arguing here, the original question wasn't about W-2s for chores, but about Roth IRAs.

Correct.  Talking about this for a few days just made it feel that way.

Roth IRAs are allowed to anyone that qualifies from birth to death.  There is no age qualification.

 

[Nords]

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

Geez, go surfing for a day and see what happens!  I'm glad I wasn't sitting around watching the blow-by-blow.

Hey, Retire@40, maybe if you use more capital letters I'll understand more quickly.  If we were sitting in the same room, would I understand this better if you spoke slowly in a loud voice?  If you can't provide a reference or a ruling or even an IRS letter, then kindly refrain from lecturing us about IRS policy.  My opinions are based on all the IRS pub reading I've done over the last few months, conversations with a CPA who's spent tons of quality time with the IRS' revenue officers, and the half-dozen magazine articles that pointed me to the issues.  So far your reference appears to be a CAPS LOCK key.

I think what we have here is a difference of opinion.  Luckily the only opinion here that counts is the IRS', not yours and certainly not mine.  While the IRS would probably not look kindly on my paying our kid to make her bed, it's not unreasonable to pay a kid to do the household jobs that I'd pay the neighbor's kid to accomplish.  And if no one's filing a W-2 on the neighbor's kid then I doubt that I'd file one on my kid-- I favor the concept of personal pay records & timesheets.  (Gee, TH, I wonder if Quicken supports this.)  And I can certainly put rental-property chores on Schedule E and back it up with a W-2.

This is diverting from the original issue of W-2 for chores and has totally different tax ramifications, but yes, because the child is self-employed in the business of mowing lawns.  The child may file a Schedule C and report all income and related expenses.  But the child will be subject to federal, state, and self-employment taxes.  Whatever is left over may be contributed to a Roth IRA up to $4K.

What I've read is that kids under 18 in the family business aren't subject to withholding for federal & self-employment taxes, and they usually have a big enough deduction ($4850 off the top of my head) to not pay any taxes.  

I'm still trying to get Hawaii's ^%$# tax website to download their pubs.  I think they turn the server off for the weekends to keep taxpayers from being able to research tax-avoidance schemes...

In any case rush hour will be over in another 90 minutes.  Still 3-5 feet on the south shore, and 8-footers predicted for Friday!  Happy Kamehameha Day!

 

[retire@40]

My opinions are based on all the IRS pub reading I've done over the last few months, conversations with a CPA who's spent tons of quality time with the IRS' revenue officers, and the half-dozen magazine articles that pointed me to the issues.

Funny how two people using the same sources can have differing conclusions.

By the way, sometimes I write slowly because I know some people can't read fast.

 

[Nords]

Funny how two people using the same sources can have differing conclusions.

A famous Navy cartoon says it this way--
A study of the differences between the Navy's warfare communities:
Nuclear submariners: "Don't do it unless the book says you can do it."
Surface warfare: "It's OK to do it unless the book says you can't."
Aviation: "Contrition is easier than permission!"

After years in the first category, I'm gonna let my hair down and go with the middle option. I think there's plenty of wiggle room for everyone to feel that their position is supported by the laws & references...

 

[Martha]

Nords, besides the compensation issue we have beat to death, think through these things:

---if you end up considering your child as self employed, she likely will have to pay the self employment tax

---as you noted above, if your child's earned income is below $4850, she doesnt have to file income taxreturns. However, don't forget unearned income which will require filing of a return at a much lower level of income and may goof up any exemption from withholding. And so retire@40 doesn't get on my case, withholding applies only if child treated as an employee.

---if you treat your child as an employee, as you indicated, the IRS has said children employed in a family business which is not a corporation do not have to have FICA and FUTA withheld. One issue we haven't talked about is whether this same exception applies if the child is employed as an employee to do work around the house, rather than employed in a business.

Gotta go to the big city for a closing.

 

[cute fuzzy bunny]

Funny how two people using the same sources can have differing conclusions.

But you havent offered any sources.

 

[Nords]

Complification

The surf was awesome.  It's been a while since I had the longboard try to race away from me while I was popping up.  I figured it out when I looked over my shoulder to see that the "little" wave had blown up to an eight-footer and was curling down over my head.  So I ran away fast...

You've raised some very good issues, Martha.  The key is how each one of those is addressed without triggering some other form of taxation or inquiry.

As I feared, the state taxes are way more complicated than the federal rules.  I just pulled up the Hawaii employer's tax guide.  (Funny how that PDF wouldn't come up all weekend but it popped up in a microsecond during business hours.)  Anyway Hawaii withholds at least 1.4% of anything that would give them more than a dollar and teenagers can't claim many exemptions.  So first I'd have to file form HW-4 and then I'd have to follow that up with $92 of withholding payments on $4000 of wages. 

TurboTax says zero federal taxes when I run through $4000 wages and ~$500 of UTMA investment income.  (Tweedy, Browne is pretty tax-efficient.)  However we'd be paying $33 state tax and thus claiming a $59 refund.

As disappointed as I am in the People's Democratic Republic of Aloha, at first glance the $33 seems like a pretty reasonable price to pay to kick off tax-free compounding.  However even a 10% return that first year would cost $33/$400=8.25%.  (Of course I'm mixing wage taxes with investment income but the point is that this whole avoidance maneuver could be viewed as having an annual 8.25% load.)

Back to the drawing board, but despite the taxes it's probably worth keeping our eyes focused on the power of the extra years of tax-free compounding. 

I wonder if all this Hawaii paperwork & taxes would catch their auditor's attention, or cause the IRS' local office to get curious. 

Glad I didn't start asking myself these questions in November...

 

[retire@40]

Re: Complification

TurboTax says zero federal taxes when I run through $4000 wages and ~$500 of UTMA investment income.  (Tweedy, Browne is pretty tax-efficient.)  However we'd be paying $33 state tax...

How can the federal tax be zero?  In this case, isn't it $25 (10% of the UTMA income over $250?) 

 

[Nords]

Re: Complification

How can the federal tax be zero?  In this case, isn't it $25 (10% of the UTMA income over $250?) 

Dude, it's zero.  Gimme a break for not regurgitating every little stinkin' detail of the tax-estimation process.*  While I am seeking ruthless criticism of a bleeding-edge tax question, I'm not trying to baffle anyone with my brilliance.

I don't know where you're getting your numbers from but when I say "~$500 of UTMA investment income" I mean that her UTMA shares of Tweedy, Browne Global Value threw off $515 of dividend income and paid some foreign taxes.  And I ran this mockup on TT for 2004 returns so if there's a tax law that affects 2005 UTMA income then I haven't learned it yet.

*(But gosh, I'll rectify that oversight now.  Let me read 2004's numbers off the hypothetical 1040:  $4000 in wages, $1 of checking-account interest, $515 of investment income from Schedule B, $4250 standard deduction (which I believe has been raised to $4850 for the 2005 tax year), leaving $266 taxable income.  The resulting tax of $13 is wiped out by a $13 foreign tax credit from TBGVX's 1099.)

Martha's point is well made that, even if the 2005 deduction rises to $4850, the $4000 of income can quickly push a tax bill from zero to positive numbers.  If that combined federal/state tax bill gets over, say, $50 then it makes me question the wisdom of paying up front to compound tax-free.  But that's just another spreadsheet that I haven't gotten around to plugging the numbers into-- although I suspect tax-free compounding will reign supreme in the end.  I'm just not sure how much hassle factor I care to endure with the paperwork, the tax bill, and perhaps a query or two from the tax authorities.

In any case I think I'm beginning to see the answers to my original questions:  "Is this deal too good to be true?  What am I missing?"  Yikes.  But at least I won't lay awake nights wondering about it...