One question that often comes up when a new parent begins considering their child’s future finances is whether they can start an IRA on their behalf. Since the time value of money is perhaps the greatest power of a self-directed IRA, it’s easy to see why parents would try to make this happen. Unfortunately, IRAs can only be opened by individuals for themselves, with money they earn themselves. Let’s take a closer look.
The Earned Income Requirement. The biggest hurdle you’ll have to overcome when you work to help your child opened a self-directed IRA is the IRS requirement of earned income. In order to make any contribution to an IRA, the account holder must have earned income of at least that amount for the year of contribution.
So, for example, let’s consider an individual who has accumulated a significant amount of assets in their non-retirement accounts and now lives off of their investment earnings. Even if that individual earns $100,000 per year in investment income, they won’t be able to make contributions to an IRA unless they have earned income as well. Earned income is essentially what someone receives in exchange for their time or services. This might be salary or commissions from their job, or income they receive from freelancing or working as an independent contractor.
A Part-Time or Summer Job. If your child is old enough to get a part-time or summer job, then whatever they make will constitute earned income. They are now eligible to open a self-directed IRA in deposit this amount.
Hiring Your Child. Even if your child has an “income” from savings or taxable investment accounts you may have set up for them, they’re not able to use those funds to open or contribute to a self-directed IRA. But if you have a home-based business or consulting career on the side, consider whether there are tasks you may be able to hire your child to do. You can’t create a “sham” position for your four-year-old, but you may be able to hire your 10 or 11-year-old child to help you with very simple tasks such as basic filing, collating or envelope stuffing. Make sure the work they do is genuine, and don’t pay them an unreasonable amount – these could constitute red flags for the IRS.
Funding the Account. It’s worth noting that the IRS rules on earned income don’t require that the account holder deposit the exact dollars that they earn. So if your child is able to earn $500 or $1,000 over the course of the year by babysitting or mowing lawns, then they are eligible to deposit that same amount into an IRA – even if it’s not the same dollars. In other words, they might spend or save what they earn, and then you could gift them the same amount that they can use to open their own self-directed IRA.
It’s important to understand that the earlier you can help your child open their own self-directed IRA, the better chance they’ll have of reaching their own retirement goals (even if they haven’t formed those goals yet themselves).