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Roth IRA for Youngsters

Sep 7th, 2011
by jblankenship.
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Many times it is among the best of ideas to establish a Roth IRA for your child.  This way, your child can benefit from the long-term growth in the account and have a very good head start on retirement savings for later in life.  There are other benefits, including the fact that retirement funds are not included when financial aid is being calculated for college expenses, as well as providing funds for the child to use when the time comes to buy a house.

One thing can cause a real problem though: if you undertake to make contributions to a Roth IRA for your child that aren’t based in fact.  What’s that?  How can this be?  So there’s a way you can make contributions to Roth IRA that aren’t based in fact?  What fact is that??

The rules for making contributions to Roth IRAs (actually, any IRA) include the fact that the person who owns the account must have earned income.  This means that the individual whose account is being contributed to must have earned at least the amount that is being contributed from some sort of job – which could include self-employment or any sort of employment.  In addition, scholarships or fellowships that are reported in box 1 of Form W2 are considered earnings for IRA contributions.

If your child doesn’t have income of any realistic form, it is not allowed for you to make contributions to a Roth IRA (or any IRA) on behalf of the child.  And it doesn’t work for you to invent income, such as paying the child to clean up his or her room.  The income has to be “real” – making contributions without some sort of real income will result in some nasty penalties.  The penalty for over-contribution to a Roth IRA is 6% per year.  If several years have gone by, you’ll get hit with this penalty for all of those years – which is even worse than just putting the money in a savings account the first place.

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Withholding Tax Without Income?

Jun 8th, 2011
by jblankenship.
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We’ve discussed in the past how it’s possible to eliminate quarterly estimated tax payments by using a withdrawal from your IRA.  But did you realize that you can actually put this method in motion without actually increasing your income?

Income tax
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Wait a minute… did you just catch that?  I’m telling you that you can eliminate your withholding or quarterly estimated taxes by using a withdrawal from an IRA – and that you can do this without having to recognize income from the IRA withdrawal.

It’s a little tricky, but if you’re not too faint of heart, this could actually be a cool little maneuver.  What you do is to take a withdrawal from your IRA, and on the withdrawal slip indicate that you want the entire withdrawal withheld for taxes.  Then, within 60 days, replace the funds (from another, non-IRA source) into either that same IRA or another IRA – effecting a sixty-day rollover.  End result: taxes withheld, no income, no penalty.

While it might seem crazy to assert that you can have taxes withheld from a distribution that was negated by a 60-day rollover, but the IRS allows you to do a tax-free rollover of a distribution that has been sent to the IRS as withheld income tax, by using substitute funds (see Rge 1.402(c)-2, A-11).

How could this be a cool maneuver?  Take the factors into account:

  • When you withhold tax from an IRA distribution, the IRS considers that it has been withheld over the course of the year, so timeliness of withholding isn’t important: you could have your entire tax burden withheld on December 31 if you wanted.
  • If you are self-employed or otherwise in complete control of your income, you can eliminate withholding and/or estimated tax payments completely, by saving up the equivalent of withholding through the year and then pulling the trick outlined above toward the end of the year.

You’d be able to very accurately calculate your tax payments, reducing the loss of income that comes along with over-withholding through the year.  This way you can invest the money that you’d otherwise be sending in quarterly installments, and at the end of the year make one large payment from your IRA, and roll-in your withholding stash.

It should be noted that, while this is a valid option to consider, there are pitfalls that could really cause you problems.  Just forgetting to do the IRA withdrawal (withholding the withdrawal to pay tax) one time can result in some very serious penalties.  Furthermore, missing the 60-day deadline for completing the rollover could penalize you further with the 10% early withdrawal penalty.

I would not suggest doing this maneuver on a regular basis – it should be one of those tools that you have available if you get caught in a pinch.  The penalties for screwing it up are too severe, and the chances of screwing it up are plenty.

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