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In a previous article I discussed a simple plan by which to help encourage your child to save their money from a young age. As mama and daddy, some of your responsibilities included not only teaching your child the importance of spending money on meaningful things, but also setting aside a small sum of money each year in order to help them save $23,400, in one of the best investment vehicles available, by the time that they are just 18 years old. If you have not yet read the referenced post, stop. Come back here after you have.
Before we continue, let me first say that while I am a personal finance enthusiast, I am not your accountant, attorney, financial planner, or financial adviser, and nothing on this website is to be construed as coming from a professional. The information provided in this article is for informational purposes only, and nothing on this website is to be considered as professional advice. As such, I, the author, am not liable for any losses or damages related to actions or failure to act in any relation to the content on this website. If you need specific financial or tax advice, consult with a certified and licensed professional who specializes in your subject matter.
Now, with that out of the way, let’s get on with it!
What is an IRA
An individual retirement account (i.e. IRA) is an account setup at a financial institution that allows an individual to save for retirement with either tax-free growth or on a tax-deferred basis. The 2 main types of IRAs, traditional and Roth, each have different advantages based on your unique personal facts and circumstances.
For 2019, the IRS has stated that an individual’s total IRA contributions can not be more than $6,000 for the year ($7,000 if you are age 50 or older), or if your taxable wages for 2019 are less than this amount, the contribution limit is your total taxable compensation for the year. Further, an individual’s combined traditional and Roth IRA contributions can not exceed these defined amounts. However, the IRS does not care who contributes money to an individual’s IRA as long as it does not exceed the individual’s maximum contribution limit for the year. In other words, a parent is allowed to contribute to their child’s IRA!
What is a Roth IRA
One of the most significant differences between a traditional and Roth IRA is that for a traditional IRA, an individual makes contributions with money that may be able to be deducted on their tax return, whereas with a Roth IRA, contributions are made with money for which taxes have already been paid. An incredible benefit of the Roth IRA, is that because the account is funded using “after-tax” money, any of the account’s future earnings will grow tax-free, and provided certain conditions are met, the future withdrawals will not be considered taxable. This caveat involving tax free earnings is an important benefit to understand, because although a typical brokerage account is also funded using “after-tax” money, realized earnings in a brokerage account are still considered taxable.
Why is a Roth IRA Ideal for Your Child
One of the most common arguments used to justify why an individual should contribute to a traditional IRA instead of to a Roth IRA is that many retirees find themselves in a lower tax bracket than they were in pre-retirement. As a result, the tax-deferred contributions (along with any earnings) in the traditional IRA may be withdrawn from the account at a lower tax rate during retirement than if the money had been taxed during an individual’s typical working years.
Although this logic is well founded, the key phrase is that they “may be taxed at a lower rate.” As a free thinking contrarian, I have to consider the possibility that as our government continues to go further into debt, it will increasingly have no choice but to raise tax rates in order to generate increased revenue. However, considering that a working child will likely be in the lowest earning years of their life, and that even if their earnings incur a tax liability, it will probably be incredibly small, it makes a great deal of sense to contribute to a child’s Roth IRA.
By 2026, in my home state, the minimum wage will be $15 per hour. Granted, in 2026 my son will only be 7 years old, we will still use this wage in our example. Also, in the state we live in, the youngest age that a minor can obtain a work permit is 14 years old. Therefore, let’s review a base scenario in order to see what reasonable earnings and intentional Roth IRA contributions could look like. Of course, I fully expect that our son will have accrued savings by the time he is at a working age, but since Roth IRA contributions are limited to the amount of the current year’s earned income, we can not consider these savings for our equation. Additionally, recall that a criteria for our base case scenario is that my son’s savings will be matched 100% by mama and daddy until he is 18 years old.
As a 13 and 14 year old, I imagine that our son will only have one consistent income, mowing a neighbor’s lawn. Even with a work permit at age 14, I do not realistically think that another form of work would be suitable. Therefore, conservatively, if our son receives a weekly wage from mowing a single neighbor’s lawn at the age of 13 and 14, it is reasonable to assume that he may earn $1,680 over the course of the two years ($30 per week x 28 weeks to mow grass per year x 2 years).
At 15 years old, I imagine that our son will have a few more work opportunities. Perhaps he will be a lifeguard at a pool in the summer. Whatever employment he may choose, I assume that he will still be able to manage mowing a single lawn for the year ($840), and that he may very easily work 12 of the 14 weeks between Memorial Day and Labor Day. Therefore, at 15 years old, our son could reasonably earn $3,600 life guarding at a pool ($15 per hour x 20 average hours per week x 12 weeks). As a result, he would have a minimum earned income for the year of $4,440.
In the remaining three years, in order to meet the goal of earning $23,400 by the time he is 18, our son will need to earn another $17,280 ($23,400 – $1,680 – $4,440). Do not forget that he will only be contributing 50% of his earned income to the Roth IRA because mama and daddy will be matching the other $11,700 to achieve the total Roth IRA balance of $23,400. This may seem like a tall order, but considering that he will be earning no less than $15 per hour, this should be a fairly easy to attain goal ($17,280 / $15 per hour = 1,152 working hours over 3 years).
At age 16, many restrictions are removed from the kind of work that a minor is allowed to perform in our state. As a result, I imagine that in addition to being able to work at a pool in the summer, he will have available to him a host of other work opportunities, some of which may increase his wage if he were to continue working for the same company as a 17 and 18 year old. However, for the sake of being conservative, let’s assume that at 16 years old our son earns another $4,440.
I presume that at 17 and 18 years old, likely having access to a vehicle, and as a result, being able to work in at least a part time capacity throughout the year, our son should be able to work 430 hours per year, and thereby earn the remaining $12,840 (($17,280 – $4,440) / $15 per hour = 856 working hours over 2 years). To prove this point, working an average of 20 hours per week for 12 weeks each summer equals 240 hours, leaving only 188 hours to be worked on a part time basis throughout the remainder of the year ((188 hours / 40 remaining weeks in the year) = 4.7 working hours per week). In truth, only working 20 hours per week in the summer as a 17 and 18 year old will likely foster an attitude of laziness and ingratitude in your child. Therefore, in addition to meeting the goal for the Roth IRA contributions, your child should be encouraged to work a few more hours, and as a result they will have even more money in their checking account, and hopefully savings account, with which they can have plenty of fun with their friends!
Here is a chart summarizing the earnings that we have just reviewed:
|Age||Earned Income||Roth IRA Contribution Limit|
As you will notice, under the current IRS tax code, at 17 and 18 years old, my son will have earned more income than he is eligible to contribute to his Roth IRA. However, 15 years ago (2004) the IRA contribution limit was just $3,000 for individuals under 49 years old. Therefore, it is very reasonable to assume that in the next 17 years the IRS contribution limit could easily increase by at least $500, to $6,500.
Based upon my research, in order to legitimize the earned income from mowing lawns (or perhaps for someone else, baby sitting), there are a few steps that mama and daddy will need to take. First, document your child’s income. This does not need to be incredibly elaborate, but it should be adequately detailed: what service was performed, how often was the service performed, how long did it take to perform the service, for what wage was the service performed, who performed the service, and for whom was the service performed. This is the sort of information which I plan to help my son diligently record.
In 2019, if payment for services equals or exceeds $600, a 1099-Misc should be filed with the IRS by the person making payment for the service. However, in the case that the form is not submitted to the IRS, having a basic document like the one outlined above should go a long way towards demonstrating the legitimacy of your child’s income.
Secondly, make sure that payments to your child are also well documented. For our son, my plan will be to create a payment schedule with which he can document the type of payment he received (cash, check, electronic, etc.), the date that he deposited the money, and the financial institution with whom he made the deposit. This schedule will likely be affixed to the detailed service agreement that I already mentioned.
It is crucial to remember during this process that you need to document all of the evidence which legitimizes your child’s income because the IRS’ stance during an audit is that the burden of proof resides with the individual. There is no “innocent until proven guilty.” Rather, it is guilty until proven innocent! Personally, my stance is to be so adequately prepared that should my child’s income ever come under scrutiny and need to be proven as legitimate, I would be able to pull out a folder and present all of the documentation that I described in the paragraphs above.
As discussed previously, through encouragement and motivation, my wife and I hope to instill into our son a strong habitual nature to save his money. As a result, it is my belief that because he will understand and value the fact that we will match 100% of his savings during these years, that he will enthusiastically contribute 50% of his earned income into his Roth IRA. Not to be dismissed or overlooked, this will still leave our son with at least $11,700 to spend however he wants. I reiterate my belief that after many years of setting aside a significant majority of all of the cash our son receives into a regular savings account, and bearing in mind that while he is 17 and 18 years old he could potentially earn even more money than I have conservatively estimated, he will likely have much more than the remaining $11,700 of earned income which he can decide how to spend on meaningful experiences and purchases, or instead save for a short term goal.
For those of you thinking that this scenario is not conservative, and is instead picturesque and idealistic, I pose two questions to you. What purchases, if any, did you make in your first 18 years of life that were actually meaningful? And, how many children, young adults, and even adults actually know how to meaningfully spend $11,700? Personally, when I look back upon my adolescence, instead of seeing meaningful and valuable purchases, I wonder why on earth I ever thought so highly of the common, trivial things which I spent my money on.
P.S. Hopefully, after learning from our example, and also reading Your Money or Your Life and Choose FI: Your Blueprint to Financial Independence, my aspirations for our son’s willingness and enthusiasm to save his money will prove to not be misplaced!