Many of our business owner clients are on the lookout for tax-savvy moves to boost income and reduce taxes. And it sure does pay to be smart with your taxes. But did you know there is a method to save on taxes — while also helping your children get on the right road to financial success?
It’s called a Roth IRA for Kids. Read on to find out how you can take advantage of this strategy.
Taking a step back, a Roth IRA is an individual retirement account funded with after-tax money that grows tax-free. Withdrawals are also tax-free in retirement, so this account gives you double the tax advantage (i.e., tax-free growth and tax-free withdrawals). Given that a Roth IRA is funded with after-tax money, it makes sense to pay those taxes when you are in a lower tax bracket. So, the best time to contribute to a Roth IRA is often when an individual is early in their career and not making much money.
The earlier you put money into a Roth IRA, the more time you allow the account to compound tax-free. Imagine five or six decades (or more) of investment growth. That can happen with the right planning. And if you happen to be a business owner, then you have the option of getting a deductible business expense out of the deal, as well.
Roth IRA for Kids of Business Owners: A Win-Win
There are rules to know about a Roth IRA for Kids.
First, the child must have qualifying earned income. You cannot simply plop cash into a Roth IRA no matter the circumstance. The child’s income must be under the qualifying threshold, but the good news is there is no minimum age requirement.
A Roth IRA for Kids is well-suited for teenagers working summer jobs or after school at a part-time position, but business owners have an added advantage. While most younger children are precluded from saving in a Roth account because they don’t have earned income, a small business owner can legitimately employ his or her children. That way, they can have wages (earned income) to use for Roth IRA contributions.
What Is Qualifying Income?
A child has “qualifying income” when he or she performs work for the firm.
It might take some creativity on your part to conjure up legitimate tasks. Here are some ideas: modeling for advertising and promotional material, cleaning services, filing services, or even social media management. The specifics are up to you, but it must be real work that earns real wages so that it qualifies as earned income.[i] Roth IRA contributions can only come from earned income. For you as the business owner, the wages are a deductible expense. What’s not to like about this strategy?
We love Roth IRAs at TreMonte. You might have already known that. We like to nag our clients about the beauty of Roths, time and again. Not only are you giving your child the gift of compounding returns, but a Roth IRA is quite flexible and features other benefits. The account owner can withdraw contributions at any time, tax-free and penalty-free. Moreover, your kids can use the money for major life expenses such as a first-time home purchase, qualified educational expenses, birth or adoption costs, and others (limits apply).
A Roth IRA is just about the perfect hybrid college savings, home purchase, and retirement account for children of small to mid-sized business owners. Along the way, you can teach your kids about the magic of compounding (hint: it’s just math). As your child watches the account balance grow, perhaps they will grasp the wonders of saving for the future instead of frivolously spending it all now. You can set them up for financial success.
Bottom line: Funding a Roth IRA for your children is a win-win. You get to deduct the wage expense. Your child benefits from decades of tax-free investment growth while paying minimal (if any) income tax today. Your child also learns — in a very real way — the benefits and responsibility of investing.
How Much Can You Contribute?
The IRS sets a maximum amount a taxpayer can contribute to a Roth IRA each year. For 2021, the amount is $6,000.[ii] The annual contribution limit is indexed to inflation, so it usually increases $500 every few years. The IRS also sets maximum income thresholds to be eligible for contribution to a Roth IRA:
- For 2021, this amount is $125k for a single taxpayer.
- If you make between $125k and $140k, the maximum contribution amount is reduced.
- You are ineligible if your income is $140k or more.
- $198k is the limit if you are married filing jointly. If you make between $198k and $208k, the maximum contribution amount is reduced. You are ineligible if your income is $208k or above.
Roth IRA contributions cannot exceed a minor’s earnings. For example, if your son or daughter makes $2,000, then $2,000 is the maximum Roth IRA contribution for the year.
The Process of Opening a Roth IRA for Kids
The process of opening a Roth IRA for Kids is straightforward.
- Choose a trustworthy provider. Don’t sweat this step — we are here to help you ensure the account is at the right place.
- Open an account for the minor. Keep in mind that the parent maintains control of investments until the child reaches adulthood (age 18 in Michigan). Once a legal adult, he or she is entitled to access and control the Roth IRA.
- Fund the account. Designate each contribution based on the tax year. Be aware that you can make “prior year contributions” up until Tax Day the following year.
- Select investments. Parents choose how to invest the cash. Once again, our team is here to help in that process. Parents are the recipients of account statements and communication.
- While you as the parent control the investments, the account itself is legal property of the minor child at all times.
Roth IRA for Kids: Benefits to a Business Owner
Strategic saving can be tough for small business owners with children. Taking advantage (legally, of course) of the tax rules is important. A Roth IRA for Kids is a great tool to help build wealth for your family. The account features flexibility along with tax advantages.
Our team at TreMonte guides small business owners through complex financial decisions to make the process easy. If you would like to discuss a Roth IRA strategy for your children, this link will take you to reserve a short call with a member of our team.
[i] https://www.irs.gov/publications/p590a#en_US_2014_publink1000230355
[ii] https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2021
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