We believe that one of the greatest gifts parents can give their children is financial freedom. One of the easiest ways to do this is by funding an IRA, while they are still minors, and letting the compounding effect of your investment do the rest.
To fund an IRA, one must have earned income. For a child, this usually means income amassed from mowing lawns, baby-sitting or other household chores. If you, the parent, pay the child for performing such services, pay with a check and keep records of the employment. The IRS should not be able to claim later that this was a “gift” or “allowance” and not earned income.
A dependent child must file a tax return if the child meets any of the following:
- Has more than $950 of unearned income (2012);
- Has more than $5,950 of earned income (2012 amounts, indexed), and/or
- Has a total of unearned and earned income, which exceeds the larger of $950 or earned income (up to $5,650) plus $300 (2012).
Therefore, a child who earns $5,000 baby-sitting and has no interest or dividends is not required to file a tax return. However, if you wish to take a $5,000 deduction for a regular IRA, or contribute $5,000 to a Roth IRA, we recommend that a tax return be filed. The return is proof that the child qualified for an IRA (earned income requirement).
When filing the tax return, record $5,000 (or whatever income is earned) on Schedule C-EZ. The net income is then carried to Line 12 on page one of Form 1040. If the child is contributing to a Traditional IRA, take the IRA deduction on Page one, Line 24. If the child is contributing to a Roth IRA, there is no form to complete.
The IRS requires self-employment tax be paid on self-employment income. Self-employment income is defined as “gross income derived from any trade or business carried on as a sole proprietor.” Note: Self-employment tax is never required on a dependent’s earned income, if that income is received from a parent.
At Henssler Financial, we maintain that mowing lawns or baby-sitting by a young person, who is still a dependent of their parents and still in school, is not performing a service as their trade or business, and therefore, not subject to self-employment tax. Henssler Financial has filed tax returns for children with baby-sitting income. No self-employment tax was calculated, and these returns have not been challenged. The tax court has affirmed the position that a baby sitter, who is under the control and direction of the children’s parents, is not subject to self-employment tax (Hodgkinson vs. Commr, TC Memo 1968-176, 27 TCM 865). We concur with this position, and maintain that dependents, who mow lawns, wash windows, tidy the house, etc., are not subject to self-employment tax.
All W-2 income is earned income, and if received, allows the individual to make an IRA contribution up to $5,000 (or their earned income, whichever is less). For parents with sole proprietorships, you might consider hiring your child and paying them through payroll. The children are exempt from social security, Medicare tax, state and federal unemployment, if they are under the age of 18. This is not the case if the parent operates their business as a corporation, partnership or other entity. Under these circumstances, the child is not exempt from employment related taxes.
This should clarify the eligibility requirement for funding your child’s IRA. By the way, this works for grandchildren as well.
At Henssler Financial, we believe you should Live Ready, and that includes setting your child up to attain financial freedom. For more information on establishing an IRA for your child, please contact the experts at Henssler Financial at 770-429-9166 or experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
