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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, for example.
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, meaning each year that the money is in the account. If several years have gone by, you’ll get hit with this penalty for each and every one of those years – which is even worse than just putting the money in a savings account the first place.
So, if your child has legitimate income, such as from mowing yards or a paper route, it’s perfectly legitimate for the child to make a contribution to a Roth IRA. You can even donate the funds to the child to make that contribution if you like. Just don’t contribute more than the child’s actual earnings.