Open a Roth IRA for Your Child

Here’s a very good idea to consider – if you have a teenager who has a part-time job, rather than putting those earnings solely into a savings account (or worse, a car), open a Roth IRA.  The money contributed to this account will mostly be tax free, since the first $5,700 (2009 figures) of earned income is not taxed for a single filer that is a dependent of another.

Since contributions to the Roth IRA are “after tax”, the first $5,000 earned (for 2009 and 2010) and the future earnings on that income will never be taxed if contributed to a Roth IRA.  And since as a parent you’re paying for most everything else that the child needs anyhow, why not encourage him to make a contribution of his first $5,000 of income into a Roth IRA?

One downside (or maybe it’s an upside?) to this strategy is that the contributions will be available (without tax or penalty) for college expenses, down payment on a home, or whatever.  However, if the money is left in the account it can provide a tax-free source of income for retirement in the future.  This can be a good time to introduce the concept of saving for something far into the future to your child.

An added benefit of putting the money into a Roth IRA account is that money in retirement accounts (such as a Roth IRA) is not included in the FAFSA calculations for student financial aid.  If this money was put into a savings account, the savings account would be counted as a source of funds to pay for college expenses (on the FAFSA).

Two key factors to remember are:

1. The child must have earned the income.  This means that the income was reported to them on a W2 or 1099, or possibly the child was self-employed.  The income must be reported on an income tax return in order to account for the income, even if no tax was owed on the earnings. (Note: don’t get carried away with this idea and “invent” income for your child.  Allowance for mowing the yard or cleaning her room does not count as income.)
2. The Roth IRA contribution must be made before the tax return is filed for the year in question.  For the 2009 tax year, for example, the contribution to the Roth account must generally be made by April 15, 2010.

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Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 20 years of experience in the industry.  . Read more from this author