Custodial IRA for Children

The Sandbox Finance/Investments
1

Anybody done one? Once a child has income, seems superior in every way to a 529. Can be used just like a 529 or saved for retirement.

Considering when my kid’s old enough, they get a job, invest their paycheck, I match it 1-1, and they get an allowance equal to their paycheck.

Thinking start with babysitting, mowing grass, shoveling driveways, etc. once they’re old enough for that to be proper, then whatever part-time McDonald’s or such they can get.

Things work out correctly, I reckon we would get about $20,000 saved up by age 18 which could either be used for college education, or saved for another 50 years and used for retirement, either way comes out untaxed.

For now I’m maxing out my Roth IRA while I can for educational purposes or personal retirement.

2

I have not done that, but it sounds like a good idea.

We did not do a 529 for reasons…mostly because of the restrictions on using the money.

What I did was invest in my own Roth IRA. “Principle” can always be taken out. There is a provision to be able to take out “earnings” penalty-free (but not tax-free) for education but I haven’t been able to quite figure out how that reporting goes.

In the end, I have enough Roth principle that I can just take that out and not have to worry about anything else.

3

(This is likely wrong as clarified) To clarify, the money was already taxed, not being taxed when you take it out, which is probably as you meant to say. Otherwise yeah, agree with you.

I have about 40% of one college education saved up, but want our expected child to learn the value of work. Should they get a scholarship, dope, have something like $300k pre-loaded for when you retire.

4

When you take it out at retirement, the earnings are not taxed.

However, I believe that if you take it out before retirement AND for education the earnings will be taxed as income but not penalized. This is based on my recollection. I’m not sure I have the energy/motivation to look it up right now…maybe tonight.

5

I believe you are correct. I misread the IRS code which was not calling it “a penalty” but instead “an additional 10% tax” which is exempted for education.

Good news for the custodial Roth IRA though, if they’re going to college full-time and not working then the earnings may be all of their “income”.

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6

Here is where you went wrong :wink:

7

?

Their biweekly allowance equals the paycheck they earned and invested.

8

You can take my paycheck from my cold-dead hands - a teenager, probably

9

I was being a bit extra “legal” about it but in reality, I’d just be investing an amount equal to their paycheck.

10

Edited - ok my point is that the kid might not want to not spend their money.

11

They get precisely the money they earn to use as they wish. An equal amount goes from me to the IRA. Point is, they need to earn that income.

12

I’m starting to understand now :slight_smile:

13

“Legally” it’s just a round robin, you invest, I pay you the allowance. Officially anyway.

14

What if they become super famous and make more money than you?!

Gotcha.

15

I think in order for a child to have earned income that can be placed in an ira, you would need to report and pay socsec/medicare taxes on it. Not sure, just waited until kids had jobs before putting money in Roths for them.

16

Yes, this is mostly correct, with two caveats. You definitely shouldn’t be putting more into an IRA than the kid’s taxable work earnings.

And you are technically supposed to be doing exactly that (report the income and pay the FICA tax) regardless of whether you’re opening a custodial IRA for them or not, but basically no one does for babysitting and lawn-mowing gigs. But the kid is technically supposed to. The income from these gigs is reported on a Schedule C.

The kid can deduct any expenses such as gas for the lawn mower or mileage if they’re driving to their babysitting gig. But then of course that reduces how much you can put in their IRAs.

Income reported on Schedule C is subject to self employment tax of 15.3% of 92.35% of the income, which works out to about 14.1%. You can only base IRA contributions on 92.35% of their self-employment income. (The other 7.65% is considered employer FICA which they have to pay since they are their own employer but doesn’t count as income.)

Caveat 1: If anyone in your family runs a business and the child works as their employee then a minor child employed in a family business is not subject to any FICA tax. The kid has to be an employee in this case with income reported on a W-2. The employer should not withhold any employee FICA taxes, nor pay any employer FICA taxes. The child’s Social Security and Medicare income is $0 for this job. The kid needs to do actual work and be paid a reasonable wage. If you are a self-employed consultant you can’t pay your kid $7,000 a year to dust your office. That’s not a reasonable wage for that job. You can pay them to hook up your new computer and printer and assemble your office furniture and run work-related errands such as picking up a toner cartridge from Office Depot. And you can even pay them to dust and vacuum your office but not more than you’d pay a cleaning lady. And you have to issue them a W-2.

Caveat 2: If a person’s self-employment income is $433 or less then the self-employment tax is $0. If the self-employment income is $434 then the self-employment tax is $61 (15.3% of 92.35%). It’s not that the first $433 is exempt… it’s just not taxed if it’s $433 or less.

If the self employment income is under $400 and that’s all the taxable income they have then the kid doesn’t even have to file a tax return. Because whomever set the rules (not sure if Congress or the IRS is responsible for this gem) is dumb and doesn’t understand the calculations, if the self-employment income is between $400 and $433 you have to file the tax return but the tax will be $0.

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17

Note that a custodial IRA is the kid’s money for financial aid purposes, whereas a 529 is the parent’s money.

Kids are expected to spend up to 100% of their own savings for college whereas parents are only expected to spend something like 14% of their savings.

I think most credentialed actuaries’ kids won’t qualify for financial aid, but someone at the lower end of the income spectrum with a SAH spouse whose kid attends an expensive school might qualify for a little need-based aid so I figured I’d mention it.

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18

Lastly, if you’re going the route of the kids own savings, look into an UGMA or UTMA account. Which one is dependent on your state. Most states are UTMA these days. I’m not even sure what the difference between UGMA and UTMA, but you won’t have a choice. (Uniform Gift/Transfer to Minors Act)

You set up the account through your favorite custodian (Vanguard, Fidelity, etc.) and you can gift the kid up to the annual gift limit each year and invest it however you see fit. The income on the account is taxable to the kid.

The kid doesn’t have to work or “work”… you can start this when the kid is a baby. It’s just a gift.

The caveat here is that at some point along the way the kid may have to start paying tax on the income. A dependent child’s standard deduction is $1,100 if they don’t work. If they do work and earn more than $750 then their standard deduction is their work earnings plus $350 (unless that’s more than the regular standard deduction).

Investment income up to $2,200 is taxable at the kid’s tax bracket which for most kids is 0%. Above $2,200 they are subject to the “kiddie tax” which means that their investment income above $2,200 is taxable at their parent’s marginal tax rate for investment income. That’s $2,200 of interest + dividends + realized capital gains earned in a year, mind you… not account balance.

So as the UGMA/UTMA account grows and the investment income along with it and the kid is a teenager with a part time job too… you might have to pay some tax on the earnings. But probably less than you as a parent would.

There are no restrictions on how UGMA/UTMA money is spent so it’s nice for stuff that doesn’t count for 529 expenses. K-12 private school tuition above $10,000 per family, going on a trip between junior & senior year of high school to look at colleges, application fees, transportation & parking expenses, room & board above & beyond what the school would charge, and probably more I’m not thinking of.

It’s a nice supplement to the 529. Like the 529, any contributions are considered gifts so keep the gift tax exclusion in mind.

It’s the kid’s money though so once they reach a certain age (usually 25, I think, but it can vary by state) they can withdraw it and spend it on hookers & blow if they want… if there’s anything left by then.

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19

Thanks for the great detail, twig!

I hadn’t realized the reporting income limit was so low ($400). Pretty sure none of my kids have violated it though, I refused to pay for yard work or babysitting younger siblings :smile:(cheap actuary).

20

Yeah anyone of any age with self-employment income over $400 is required to file a tax return. It’s because you pay FICA tax on the income over $400.

It’s just that you pay the FICA tax on the income after multiplying it by .9235 but the filing threshold is before you multiply it by .9235.

If you’re wondering why the tax applies at such an odd number it’s because

.9235 * 433 < 400
.9235 * 434 > 400

Perfectly logical government operation going on there!

And $400 is the cutoff.