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 $5,500 (for 2018) or total taxable compensation. It’s very important to know what exactly can be considered “taxable compensation” for this purpose. Because the rule is, that if you don’t have taxable compensation, you can’t make a contribution to a Roth IRA.

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 if 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, sometimes well-intentioned parents get the idea to invent income in order to qualify to make a contribution to a Roth IRA for the child.

Taxable compensation doesn’t mean that whoever earned it must pay tax. It does mean that the compensation is counted as taxable on a tax return – but if the income is less than the threshold for taxation, there would be no tax on that income. For 2018, earned income less than $12,000 can be completely tax-free, since the standard deduction is $12,000. If there is legitimate earned income, this can be an excellent time to contribute to a Roth IRA – this money will forever be tax-free!

Don’t Invent Income

In general, if an activity isn’t something that you would normally have to pay someone to do (like feeding the dog, making the bed, doing the dishes, etc.) then it’s probably not taxable compensation you’ve paid the child. If the child is doing an activity (mowing the lawn, for instance) 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! And you might think that it’s not a big deal, but to invent income is tax fraud, and it can be very strictly enforced and penalized.