Kids & IRAs.

[Nords]

Just finished our tax return and now it's time to start on the kid's. Since I'm in classic hypercaffienated work-avoidance mode, it's probably better to post this pondering than to waste an hour on Solitaire.

I'm suspecting that the IRS is not making it easy to figure out how to do this, but now that our kid has discarded dressage we have some budget room to fund her IRA. (Let that be a warning to other parents the next time your toddler says "Look Daddy, HORSIES!")

I understand that this should be one's lowest savings priority after home, retirement, college, infrastructure replacements, & so forth. That's already in the budget. We're not impoverishing ourselves to give our kid a higher standard of living; spouse just happens to be finding plenty of work this year and we're only pointing the discretionary spending in another direction. (I'm not putting any more money in Nortel stock.) But we're also compelled by the prospect of four or five decades of compounding power, especially when the contributions can be withdrawn without penalty for unforeseen expenses (like more college, or caring for your elderly parents).

So how does one bequeath up to $4000/year of earned income upon one's progeny? She could arguably perform up to $333.33/month of child labor on the rental property or helping with home improvement projects. Do we property managers have to issue a 1099-MISC or a W-2, or is it just included on our Schedule E and the kid's 1040? Do we pay Social Security or other payroll taxes? Is this an IRS audit red flag? Anyone doing this with their kid(s)? Is there a website, a book, or an IRS pub that we can reference? Any other lessons learned?

 

[KB]

I opened Roth IRAs for my kids when they were about 15 or so. Their earned income was from babysitting, mowing lawns, etc. I filed a tax return to support the amount put in the Roth IRA and IRS send me a postcard letting me know that the income was below the threshold and no Tax return was necessary.

So I left it at that.

 

[azanon]

Since i think the chances of me outliving my kid is relatively low, my IRA for him will be my estate. That should be more than enough, at least for my contribution to him.

 

[soupcxan]

Here's something similar to what KB said:

http://moneycentral.msn.com/content/Taxes/Preparationtips/P33215.asp?Printer

 

[Nords]

Thanks. I hadn't considered the exemption on SS for the under-18 crowd. (I don't think it was that way when I had a high-school job!)

I particularly like the idea of issuing a W-2 (to document the earnings) and then having it wiped out by the standard deduction. I also think this beats the heck outta 529s and Coverdells while offering much more flexibility...

 

[MooreBonds]

So how does one bequeath up to $4000/year of earned income upon one's progeny?

Nords,

I think I remembered reading where you do NOT have to issue a W2 to an employee (child or adult) IF the total earned wages are less than $600/year. I'm not positive on this, but it might be an easy way to get her to earn at least that much without much hassle/documentation....

--Peter

 

[Nords]

I don't know about W-2s (yet) but that $600 limit applies to 1099s.

I have a lot of reading to do...

 

[ESRBob]

Here's something similar to what KB said:

http://moneycentral.msn.com/content/Taxes/Preparationtips/P33215.asp?Printer

Wow, Soup, thanks for this link.

I really think this one has legs. I was intrigued, btw, by the assertion that the kid has an exemption, but that since you give more than 50% of the kid's support, you can also continue claiming the kid as an exemption. In my mind, that is the key to making the whole thing work-- it is what provides the shelter on the kids income. Does this sound right to everybody?

But even unsheltered, getting your kid a Roth is a great legacy to give them.

One son 9, the other 13. Time to get cracking!

If anybody hears any thing casting doubt on the merits of this plan, or giving it more credence, pls let us know.

 

[retire@40]

The guy that wrote that article makes it sound like he invented something new and he's taking credit for it.

It's a strategy that's been around for decades.

He's definitely an amateur by the way he writes and he does make a few mistakes in his article, but generally he is correct.

 

[jj]

just curious - what mistakes?

 

[retire@40]

just curious - what mistakes?

For one, he says "Similarly, you could give the money to your child as a gift, but any income that's earned is taxed at the parent's marginal tax rate until the child is at least 14 years old. "
Not true. It's taxed at the parent's marginal tax rate only if the investment income is over $1,600. And then, only the amount over the $1,600 is taxed at the parent's highest marginal tax rate.

 

[Nords]

I was intrigued, btw, by the assertion that the kid has an exemption, but that since you give more than 50% of the kid's support, you can also continue claiming the kid as an exemption.

The kid gets an exemption while you get both an exemption and the deduction.

(I'm only conversant enough with the vocabulary to handle these questions in the 30 days before April 15th.)

You know that one kid chews through far of your support than a measly $4000 IRA contribution! With two kids is it squared or cubed?

 

[ESRBob]

It just seems odd to me that the kid gets his own exemption, for earned income and you get to claim him/her for another exemption on your taxes. Each one of these exemptions shelters $3100 so I wouldn't think they'd just give them away. But if it is true, then the whole scheme has legs.

Am I right that you would only get to deduct the payments you made to your kid if you run a profit and loss business (Schedule C) that attempts to make a profit, and you are able to pay the kid to do legitimate services to that company?

Or can you have him 'clean your home office' or some such?

 

[retire@40]

The kid gets an exemption while you get both an exemption and the deduction.

(I'm only conversant enough with the vocabulary to handle these questions in the 30 days before April 15th.)

Not conversant enough

The kid gets to use his standard deduction while you get to claim an exemption for the kid. You can't double dip on exemptions.

 

[ESRBob]

Even with the kid's standard deduction, my accountant is in the process of showing me that this isn't as good as I'd originally thought:

Basically, he says it would only really work if you were self-employed, meaningfully profitable, in a high tax bracket yourselves, and already had employees (payroll system in place).

Otherwise, he reckons you and the kid spend about 50 cents for each dollar you are able to get into the IRA, what with the self employment tax the kid pays, (15%) and medicare and so forth, plus this might push the kids other investment income, if any, into higher brackets, and then there is the several hundred dollars a year to have a payroll service or accountant file the paperwork for all the W2s and quarterly filiings etc. In the end, he just doesn't think it would work well for me, though, again, a self-employed person with meaningful income and infrastructure in their company could add this on with little extra effort and have all the costs deductible.

My take away is that it is all about the details of you and your kids' relative tax rates and situations, and not something that can be blanket applied especially for those in ER with little or no earned income and little or no income taxes.

 

[retire@40]

...with the self employment tax the kid pays, (15%) and medicare and so forth

Who said the kids pay self-employment tax on their wages? They don't.

 

[Nords]

Basically, he says it  would only really work if you were self-employed, meaningfully profitable, in a high tax bracket yourselves, and already had employees (payroll system in place).  

Otherwise, he reckons you and the kid spend about 50 cents for each dollar you are able to get into the IRA, what with the self employment tax the kid pays, (15%) and medicare and so forth, plus this might push the kids other investment income, if any, into higher brackets, and then there is the several hundred dollars a year to have a payroll service or accountant file the paperwork for all the W2s and quarterly filiings etc.  In the end, he just doesn't think it would work well for me, though, again, a self-employed person with meaningful income and infrastructure in their company could add this on with little extra effort and have all the costs deductible.

Maybe your accountant's kids are too old.

First, and I need to confirm this by researching the IRS pubs, kids under 18 don't pay SS or Medicare taxes.

Second, we're talking a $4K IRA contribution which is well below the standard deduction.

Third, I wouldn't have to pay anyone for paperwork. Learning how to do my own 1099-MISCs for a small non-profit only took a couple hours of research. It actually took longer to swear at Quickbooks' stupid data-entry system than it did to figure out the IRS rules. I suspect W-2s won't be much harder. And there won't be any estimated payments or associated paperwork.

Finally, this is a way to shelter $4K a year from taxes with the returns growing tax-free. It'll go into a Fidelity brokerage account and it'll be invested in a small-cap value index like the S&P600/Barra Small-cap Value ETF (IJS) for an $8 commission , 0.25% ER, and free dividend reinvestments. (Admittedly I'm not sure about Fidelity's custodial rules for minors' brokerage accounts, but our balance is probably big enough to put them in a cooperative mindset.)

The result is an investment that'l cost $18 bucks the first year and roughly $10-12/year for the next several years. It won't be my money anymore but that's still better than a UGMA (with its potential taxes). It won't be restricted to educational purposes and it beats the heck outta 529 costs or the Coverdell limit. The contributions can be withdrawn tax- and penalty-free (e.g., for college expenses) and the returns can also be withdrawn to pay for a first-time home purchase.

Where's the catch?

 

[Mr._johngalt]

I agree with Nords, and I would add that there is a lot
of gold in similar situations if you do your homework.
I already have the corp. in place, but am so lazy that
I won't dig and ponder as everything works smoothly
now and I don't want to complicate things. I am quite
certain there is money to be made (saved) there, but
I would need to ferret out the ways and then it would mean more paperwork. Bah humbug!

JG

 

[HnE]

http://fairmark.com/rothira/minors.htm



HnE

 

[ESRBob]

Who said the kids pay self-employment tax on their wages? They don't.

Will get to the bottom of this this week, but I probably misspoke about SET -- still, doesn't the child need to pay a regular SS/Medicare/FICA withholding, and you, the employer, pay the same on the employee's behalf, meaning that together, the two halves would equal the SET in dollar amount?

Or are you saying a child earning a small amount of income would not need to pay SS/Fica/Medicare at all? If not, why not?

Nords, the concern about hassle my accountant had, (remember, this was first blush look the week before 4/15 -- he promised to look this over in more depth during the coming days), was filing the payroll taxes with the feds. If that turns out to be moot, then agreed, that cuts out most of the hassle factor.

In my case the kids have other unearned income from other moneys we have given them, and he was concerned that the additional salary income would push them into higher brackets for this other income, which was where I started to get discouraged.

The link above to Fairmark suggests though that home chores will never be earned income, so that at least is out. Taking care of your rental property sounds good, though!

 

[retire@40]

...still, doesn't the child need to pay a regular SS/Medicare/FICA withholding, and you, the employer, pay the same on the employee's behalf, meaning that  together, the two halves would equal the SET in dollar amount?

No. Not if the child is working for his parent's sole proprietorship. This is not a revalation. It's been known for decades.

 

[Mr._johngalt]

I employed my kids in various businesses I ran
(ex wife too. She did a good job even though she
was sleeping with the boss ). It was strictly to give
them income, no other purpose. I am kind of envious of friends who have kids who eventually
take over their business. I think that's neat!

JG

 

[ESRBob]

I went over all this with my accountant friend and think I have it understood now -- wrote it all out to be clear below. He made a point of saying that doing chores at the rental property could work, but has its own separate rules which I don't understand yet. For a family with mom and/or dad self-employed, here's how it works:


First, to fund a Roth IRA, the child must earn income. It will work best if you have your own profitable sole proprietorship, and can verifiably employ your child doing work for the company. Perhaps your child does filing, runs products to customers, cleans the office, does clerical work and mailings.

To maximize the benefit, aim to have the child earn, from you or other sources, at least $4,000 a year. If you are an S-Corporation or LLC, your child will need to pay regular social security and unemployment taxes, but if you are a sole proprietorship, these are waived for children working in the family company.

The child's low earnings will also be shielded from income tax, due to their standard deduction and the nature of the tax tables. These earnings, essentially all after-tax earned income, can then be used for their annual contribution to a Roth IRA.

Hope this helps.

 

[Nords]

Thanks, Bob, it does help. I need to go over the details with my brother-in-law the CPA when he visits next month. For some reason he's always reluctant to discuss these tax-avoidance schemes via e-mail!

I understand the pros & cons of S, C, & LLC but we've never bothered. If we lost our "dream tenants" I might make the liability leap but our umbrella-liability insurer doesn't require it. So I've never filled out a Schedule C (yet) and all our numbers go into Schedule E. I'm still fuzzy on the details of issuing a W-2 or a 1099-MISC and avoiding audit triggers...

 

[Nords]

The People's Democratic Republic of Hawaii

I've learned a lot in the last six months.

To recap the concept, the idea is to pay our 13-year-old kid up to $4000/year to fund a Roth IRA. At $8/hour that works out to 500 hours or about 10 hours/week, which complies with child labor laws. That work goes into our rental property (yardwork, painting, & maintenance), to more of the same at home, and for developing websites.

First comes the federal paperwork. IRS Pub 15 (Circular E) says "Payments for the services of a child under age 18 who works for her parent in a trade or business are not subject to social security or Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child. If these services are for work other than in a trade or business, such as domestic work in the parent’s private home, they are not subject to social security and Medicare taxes until the child reaches age 21. However, see covered services of a child or spouse later. Payments for the services of a child under age 21 who works for his or her parent whether or not in a trade or business are not subject to federal unemployment (FUTA) tax. Although not subject to FUTA tax, the wages of a child may be subject to income tax withholding." Good-- no tax for SS, Medicare, or FUTA.

Withholding is a different issue. Pub 505 says that a kid with $4000 earned income and more than $250 unearned income is subject to withholding. Crunching through W-4 allowances and Pub 15 to the withholding tables shows that the amount to be withheld is... $0. Good.

The only federal paperwork appears to be a $4000 W-2 at the end of the year.

Second comes the state paperwork. Hawaii is a completely different matter from the IRS rules. Tax-wise there's no real distinction between employing your kid and employing a non-family grownup. Asking the state tax people about employing my kid got me a lecture on child labor laws and a transfer to the labor people. After the labor people reassured me that the 10 hours/week is no problem, I finally got back to the tax people to learn that (1) I'd have to change our business license to include employer's withholding and (2) I'd have to file a state version of the W-4 & payment vouchers. Crunching through the Hawaii Employer's Manual and Form HW-4 showed that I'd be withholding $58.72 for the kid's $4000 income. When I asked about unemployment & workmen's comp I got sent back to the "labor" people. Luckily Hawaii doesn't make family employees pay unemployment tax, and kids aren't eligible for workmen's comp until they turn 18.

So that's a state form BB-1X and HW-4 plus a withholding payment voucher. The state earned income report is part of the federal W-2. No electronic filing required.

The actual taxes due are not what I expected. Assuming the kid's UTMA has about $500 of dividend income this year gives an AGI of $4500. Federal tax works out to 0 (the standard deduction is $5000) and state tax is a whopping $60 (only a $1500 deduction). I guess it should be reassuring to see that the state withholding and state tax work out so closely, but Hawaii taxes sure kick in a lot faster than the feds despite Hawaii's claim to lower brackets.

The original point of this exercise was to fund a Roth IRA! I'd prefer to consolidate our accounts at Fidelity (where we already have most of the retirement portfolio) but Fidelity doesn't provide IRA custodial services for minors. Vanguard will do that but of course we'll be subject to a low-balance fee and their customer-service reputation fills me with foreboding. T. Rowe Price will also take care of minor's Roth IRAs but their expenses are much higher than Fidelity or Vanguard. Admittedly we're talking up to $40/year for up to a 1% ER on a $4000 IRA, so nuisance fees might be a much bigger impact than ERs. Of course once the kid turns 18 the custodial duties will be transferred to Fidelity.

I'm beginning to realize why every parent in America doesn't rush out to fund their kid's Roth IRA. I think we've tap-danced through the minefield of justifying earned income (not household chores) and I think the kid is old enough for us to argue that we're getting actual labor in exchange for the earned income. The state tax, perhaps an extra 80 or 90 bp of ERs above Vanguard & Fidelity, and any annual IRA maintenance fees will cost $70-$100/year (for another five years) to permanently shield $4000/year ($5000 starting 2008) from taxes.

One trick to avoid some fees would be to open the Roth IRA next January, fund it with a $4000 contribution for 2005, and then send along a second $4000 for the 2006 contribution. That gives me plenty of time to compare T. Rowe Price's expenses against Vanguard's potential hassle factor and decide if that's worth the savings.

The paperwork isn't much fun, but it's better than reactor plant manuals and I can certainly make the time for it. For the next 47 years of compounding, the expenses are also worth the effort. A Roth IRA has the advantage of shielding money that can be withdrawn for college or a house down payment without the tax implications or other restrictions of UTMAs & 529s. And this whole recap will be highly amusing to my BIL-the-CPA.

Your state's tax laws may vary. I sure hope they're less of a hassle than Hawaii.

Gosh, since I have a plan for the kid's Roth IRA, now I can get started on this year's parental Roth IRA conversions...