Editor: Albert B. Ellentuck, Esq.
Establishing an individual retirement account (IRA) in a child’s name can be an effective planning technique for a child with earned income. An IRA can enable a child to shelter investment (portfolio) income from taxes (if a traditional IRA is used) and establish a retirement fund that can take advantage of many years of tax-deferred growth.
The usual IRA rules and limitations apply. Thus, for 2012 a child must have legitimate self-employment or wage/salary income, and the annual IRA contribution cannot exceed the lesser of $5,000 or 100% of earned income (Sec. 219(b)(1)). The IRA account must be established and funded by the original due date of the return, excluding extensions. The rules barring a Roth IRA contribution or deduction for a traditional IRA contribution (i.e., participation in an employer-sponsored plan and modified adjusted gross income in excess of a certain threshold) apply to a child but will normally not be a factor. Thus, a child’s contribution to a traditional IRA (vs. a Roth IRA) will generally be fully deductible.
The key to contributing to an IRA is that the child receive earned income. For a child, earned income can come from a variety of sources, including part-time jobs, summer jobs, or activities such as baby-sitting, lawn mowing, or paper routes. Working in a family business is convenient and provides flexibility, but as in all cases in which a child is employed by his or her parent(s) or an entity controlled by the parent(s), the IRS can be expected to scrutinize carefully whether the income was in fact earned, and at a reasonable hourly rate for the work actually performed.
Traditional IRA Shelters Child’s Portfolio Income
Clients are often frustrated when their children must pay income tax on what seems like a relatively small income. This is particularly common for parents who have saved for a child’s college education using a Uniform Gifts/Transfers to Minors Act (UGMA/UTMA) or similar account. The disallowance of a personal exemption deduction because the child can be claimed as a dependent on his or her parents’ return, and an often reduced standard deduction, are normally the main causes children incur a tax liability.
Example 1: Assume that F and M are in the 25% tax bracket and recently began saving for their 15-year-old daughter D’s college expenses by regularly putting aside funds in an UGMA account in her name. In 2012, these funds produced $2,200 of interest income. Also in 2012, D earned $2,050 from a part-time job.
Because D can be claimed as a dependent on her parents’ return, she is not allowed a personal exemption deduction (Sec. 151(d)(2)) and her 2012 standard deduction is the greater of (1) $950 or (2) the lesser of $300 plus her earned income or $5,950 (Sec. 63(c)(5); Rev. Proc. 2011-52). As a result, D’s $2,050 of wages are completely offset by her standard deduction but the $2,200 of interest income creates a $235 tax liability.
One way to shelter D’s investment income is by making a deductible IRA contribution. If D makes a $1,900 traditional IRA contribution for 2012 (most likely with funds provided by her parents), her 2012 tax liability drops to zero, as shown in Exhibit 1.
IRAs and the Kiddie Tax
Under the kiddie tax rules for 2012, the investment income of a child (1) who is under the age of 18, regardless of the amount of the child’s earned income, or (2) whose earned income does not exceed one-half of the child’s support and who is either age 18, or age 19–23 and a full-time student, is taxed at the parents’ marginal tax rate to the extent such income exceeds $1,900 (Sec. 1(g)). (The rules are somewhat more complicated if the child itemizes deductions.)
As shown in Example 1, if the child has earned income (and the kiddie tax otherwise applies), an IRA can reduce or eliminate the impact of the kiddie tax. The tax savings from an IRA deduction may be more dramatic when it shelters investment income that is otherwise subject to the kiddie tax because of the parents’ higher marginal rate at which the income is taxed. Because of the complex interplay between the regular tax and the kiddie tax, practitioners should project a child’s tax before recommending whether it is tax beneficial to make an IRA contribution for the child.
Establishing a Roth IRA for a Child
Establishing and funding a Roth IRA for a child can provide significant future retirement funds, combined with tax-free withdrawals. Contributions to a Roth IRA are nondeductible, but, if certain conditions are met, distributions are tax free.
Since Roth IRA contributions are not deductible, the child’s investment income is not sheltered. But this is a small price to pay when considering the power of tax-free compounded earnings inside the IRA combined with the ability to withdraw funds tax free upon retirement. Thus, the Roth IRA generally is the preferred type of IRA when establishing one as a retirement fund for a child.
Earnings accumulated within a Roth IRA can be withdrawn tax free after age 59½ (if it has been at least five years since contributions were first made). However, the contributions to the Roth IRA can be withdrawn tax free at any time. A withdrawal from a Roth IRA is treated as coming first from contributions to the account, not the earnings. This may also provide a source of tax-free funding for college or other financial needs the child may encounter later on.
IRA as a Child’s Retirement Fund
Establishing and funding an IRA for a child can potentially provide a significant retirement asset. Because a child is typically about 50 years away from retirement age, a single year’s contribution could produce astounding results by taking advantage of an extended period of tax-deferred compounded earnings.
Example 2: Continuing with the preceding example, assume that D retires 50 years after making the IRA contribution. Exhibit 2 shows what would be available in her IRA at retirement based solely on one $1,900 contribution.
If D or her parents are willing (and D is eligible) to fund an IRA for her for several years, the results are even more impressive. For example, by investing $1,900 annually to yield either 5% or 10%, a series of just four IRA contributions could produce the results shown in Exhibit 3.
Note: The interest rates used in this example are for illustration purposes and may not reflect current market conditions.
The effect of compounded earnings is dramatic over a long investment horizon. The IRA balance at the end of 50 years (or whatever other time frame) would be the same regardless of whether the IRA were a traditional or Roth IRA. Because Roth IRA withdrawals are not taxable, the after-tax results would significantly favor establishing a Roth IRA rather than a traditional IRA. In addition, Roth IRAs do not have minimum required distributions, so funds can continue to grow tax deferred after age 70½. Of course, the tax rules 50 years from now could be dramatically different than today.
The power of a long investment period and tax-deferred compounding is more obvious when comparing the results of an IRA funded as a child with what would be needed to generate the same retirement funds with an IRA funded as an adult.
Example 3: Assume the same facts except that no IRA contributions are made for D while she’s a teenager. To replace the retirement balance she could have had (using a 10% earnings rate), D needs to begin making annual IRA contributions of $3,000 at age 30 and continue for 35 years. If she does this, at retirement she will have made $105,000 in contributions ($3,000 × 35) and accumulated an IRA balance of $813,074. Compare this with the $777,717 she could have had with only four $1,900 contributions during her teenage years.
Note: Although the maximum IRA contribution limit increases periodically, up to $5,000 in 2012, the authors use a constant $3,000 contribution for purposes of this example.
This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 13th Edition, by Anthony J. DeChellis, Patrick L. Young, James D. Van Grevenhof, and Delia D. Groat, published by Thomson Tax & Accounting, Fort Worth, Texas, 2012 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.