Don’t “Invent” Income!

Seems like a no-brainer – why would anyone want to “invent” income?  That just means you’ll have to pay tax, right?  Not always, especially if the income is for a minor and is only a relatively small amount – say, enough to qualify for the maximum Roth IRA contribution, for example.

This is a follow-up to the article Open a Roth IRA for Your Child, where we talked about how beneficial it can be to set up one of these accounts for your child. One of the points we talked about in that article was how the account can only be funded with of the lesser of $5,000 (for 2010) or total taxable compensation.  It’s very important to know what exactly can be considered “taxable compensation” for this purpose.

Taxable Compensation

Of course, any wages reported in Box 1 of a W-2 form from the employer is considered taxable compensation.  In addition, any tips, professional fees, or other amounts you receive for providing personal services are compensation as well.  If your scholarship or grant is included in Box 1 of a form W-2, this is also considered taxable compensation.  Commissions, self-employment income, alimony, military differential and non-taxable combat pay (even though it’s non-taxed!) are also included in determining the total amount of taxable compensation for the purpose of determining IRA contribution limits.

But most of these sources of income are not common for children, especially younger children – unless they happen to make money as a model, actor, or other sort of entertainer.  Usually for younger children the paper routes, lawn mowing, and babysitting jobs are just a bit beyond their reach.  So, well-intentioned parents often get the idea to “invent” income.

Invented Income

In general, if the activity isn’t something that you would normally have to pay someone to do (like taking out the trash, making your bed, doing the dishes, etc.) then it’s probably not taxable compensation you’ve paid the child.  If the child is doing the activity for your neighbor for a reasonable compensation then that’s a different story – just use your head and make sure that it’s really compensation and not an allowance.  You’re doing this to help the child get started with a Roth IRA – not to establish a criminal record as a minor!  (Okay, not exactly a criminal record, but definitely afoul of the IRS – just as bad at any age!)

Photo by Jef Poskanzer

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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