IRAs for Kids?

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We know the iPod is beckoning, but children who put even a little of their summer earnings in an IRA make out well down the road.

Hey kids! Want a neat-o idea for how to use your summer job money? How about opening an Individual Retirement Account? That's right: an IRA! I know you might be more interested in having a little spending cash for the weekends or saving for a car. But saving for retirement can be cool, too, right? Right? Um. Hello?

OK, I admit that convincing your kids to use their summer earnings to invest in an IRA is a pretty tough sell. But in all seriousness, it's an excellent idea — and one that might not be too outlandish if you encourage your child simply to allocate a small portion of his or her earnings to the cause. (You could even sweeten the pot a little by offering a "match" in the form of a little extra spending money.) Not only will very small contributions add up to significant savings come retirement, but it's also a way to teach your child an invaluable lesson — one he or she isn't likely to learn in school.

Developing savings habits — and learning the discipline to sacrifice a bit now for gains further down the road — is a skill many folks don't learn well into adulthood. (Let's face it, some people never learn it.) Opening an IRA account also provides a chance to teach your kids about stocks, mutual funds and the basics of investing. Trust me, the lesson will be a whole lot more interesting when it's their hard-earned dollars on the line.

And even relatively small contributions can add up big over the long haul. Say your teenaged child pays $1,000 into an IRA each year for three years, starting this year. After 45 years, the account would be worth $88,843 — assuming an 8% annual return. Bump that up to $1,500 for each of the three years and the IRA would be worth $133,265 in 45 years. Not bad for mowing a few lawns.

Sold yet? Good. Here's the scoop on how to get Junior started.

The Basics
Under our beloved tax system, all that's required to make an IRA contribution is earned income. Age is irrelevant. So if your child earns some dough this summer from, say, cleaning pools, dog sitting, working as an employee of your small business (more on that later) or whatever, the kid is entitled to make an IRA contribution for the 2004 tax year.

Specifically, for 2004, your child can contribute the lesser of:

1. her earned income for the year or

2. $3,000.

For 2005 through 2007, the IRA contribution limit rises to $4,000 (or earned income if less). For 2008 and beyond, it rises again to $5,000 (or earned income if less).

Your kid can contribute to either a traditional IRA or a tax-free Roth IRA. The contribution limits are the same for both types of accounts.

The Roth IRA Is the Way to Go
For a kid, contributing to a Roth IRA is usually the best alternative. Why? With this type of account, original contributions can be withdrawn at any time for any reason. (That said, earnings generally cannot be withdrawn before age 59 1/2, without triggering taxes and a penalty.)

Granted, it's pretty much always a better idea to simply let the account grow until retirement, at which point withdrawals can be taken completely tax free. (Don't underestimate the significance of this: It's a huge gift from the government.) But this might be an easier sell if you explain to your child that he doesn't have to wait roughly four decades to access his summer money.

In contrast, if your kid contributes to a traditional IRA (which offers an upfront tax-deduction on contributions), most or all of the subsequent withdrawals will be taxed. To boot, withdrawals before 59 1/2 will be hit with a 10% penalty tax, unless the money is used for certain IRS-approved reasons (one of those reasons is to pay college costs).

Another reason for shunning the traditional IRA is because your child may not actually be entitled to any tax deductions for his contributions. Why? Because an unmarried dependent kid's standard deduction automatically shelters up to $4,850 of earned income for 2004 ($5,000 for 2005). So unless your child's job paid more than $4,850 or he had income from other sources (like dividends and capital gains from a trust or custodial account), contributing to a traditional IRA won't generate any current tax savings.

Finally, the fact that your child owns an IRA (Roth or traditional) won't cause him or her to lose out on any financial aid benefits at college time. Why? Because the financial aid number crunchers don't count IRAs as assets. In other words, IRAs are invisible when it comes to determining financial aid eligibility. In contrast, a Coverdell Education Savings Account (formerly known as the Education IRA) is counted as an asset owned by the child who is named as the account beneficiary.

If You're Self Employed, Hire Your Kid
If you run a small business as a sole proprietorship or husband-wife partnership, hiring your under-age-18 child as a part-time employee of your business can be good for both of you. Here's why:

• Your child can contribute to a Roth IRA and pile up lots of tax-free bucks.
• If the kid is under 18, her wages are exempt from Social Security, Medicare and Federal Unemployment Taxes (FUTA). (This loophole applies equally to single-member LLCs treated as sole proprietorships for federal tax purposes and husband-wife LLCs treated as husband-wife partnerships.)
• You can deduct your kid's wages as a business expense, which lowers both your income and self-employment tax bills. If you live in a state with a personal income tax, it lowers your state income tax bill too.
• For 2004, the first $4,850 of your child's wages is sheltered from the federal income tax by the kid's standard deduction (assuming she has no other income). The standard deduction for 2005 is $5,000.

If your small business is set up as a corporation, your kid's wages are subject to Social Security, Medicare and Federal Unemployment taxes, regardless of his age (same as for any garden-variety employee). But you still get the other tax breaks listed above. Although in this case, you deduct the kid's wages as a business expense on your corporation's income tax return.

Bottom line: Hiring your child is one of the most tax-smart things anyone can do. Just remember to pay a wage that is reasonable for the work done, keep proper time records, and take care of those W-2s — just like you would for any other employee.