How to Start a Roth IRA for my Child

The ability to start a Roth IRA for your child largely hinges on whether he or she has earned income, as defined under the Internal Revenue Code. For individuals who have a business and the ability to pay their children for real, business-related work, starting a Roth IRA for a child can be a viable option. If you don’t have your own business, paying your own child is generally not realistic. In that case, you would need to wait until he or she is able to earn income independently through employment or self-employment.

Key Points

• The Roth IRA is one of the most powerful long-term savings tools for young investors
• You can start a Roth IRA for your child, but only if he or she has bona fide earned income
• So long as earned income exists, Roth IRA contributions may come from any source, subject to annual limits

The Power of the Roth IRA

The secret sauce to generating tax-free wealth at retirement starts with the Roth IRA. Mix in time and patience, and you have a powerful long-term strategy. All investments held inside a Roth IRA grow tax-free, and qualified withdrawals are not subject to federal income tax.

To qualify for tax-free Roth IRA withdrawals, the account must have been open for at least five years and the account holder must be at least age 59½, with certain limited exceptions.

Unlike traditional retirement accounts, which are funded with pre-tax dollars, Roth IRAs are funded with after-tax money. While there is no upfront tax deduction, this is generally not a disadvantage for a child earning modest income.

The earlier a Roth IRA is established and funded, the longer the assets have to grow tax-free. For example, if an IRA were established for a 15-year-old and $2,000 were contributed each year until age 70, earning an assumed annual return of 7.5%, the Roth IRA could grow to approximately $1.5 million, all potentially tax-free. By contrast, starting the same contributions at age 35 could result in a balance closer to $330,000.

This example is for illustrative purposes only and assumes consistent contributions and investment returns. Actual results will vary.

Starting a Roth IRA for Your Child

Starting a Roth IRA for a child is easier than ever. Because minors cannot legally own retirement accounts outright, a custodial Roth IRA must be established, with a parent or legal guardian acting as custodian until the child reaches the age of majority under state law.

Once the account has been opened, the child’s earned income for the year may be contributed to the Roth IRA. While the contribution itself may come from a parent, grandparent, or other source, total annual contributions may not exceed the lesser of the child’s earned income or the annual IRA contribution limit in effect for that tax year.

Roth IRA contributions are not tax-deductible and therefore do not reduce taxable income for the parent or child.

For a visual explanation of how Roth IRAs for children work, watch the video below:

The Roth IRA & Child Compensation Rules

In order to pay a child compensation for services, those services must be performed as part of a bona fide employer-employee relationship, and the compensation must be reasonable based on the nature of the work performed.

If you do not operate a legitimate business, you generally cannot pay your child for services. This does not prevent your child from contributing to an IRA; it simply means the earned income must come from another source, such as employment with a third party.

Paying a child to clean their room, do homework, or perform household chores does not constitute earned income for IRA purposes.

All wages paid to a child must be properly documented, reported, and processed through payroll in accordance with federal and state tax laws.

Depending on the business structure, wages paid to a child may be exempt from certain payroll taxes, although income tax reporting requirements still apply.

Revenue Ruling 72-23

Revenue Ruling 72-23 provides guidance on how the Internal Revenue Service evaluates an employer-employee relationship involving a parent and child.

In the ruling, the IRS considered whether wages paid by a father to his unemancipated minor child for personal services rendered as a bona fide employee were deductible as ordinary and necessary business expenses. The ruling concluded:

“Where the facts show that actual services are rendered by a taxpayer’s child as a bona fide employee in the operation of the taxpayer’s business, and that the compensation paid for such services is reasonable and constitutes an ordinary and necessary expense of carrying on such business, such wage payments are deductible as a business expense for Federal income tax purposes.”

As a result, the child was deemed to have earned bona fide income, making the compensation eligible for IRA contributions, while the business was allowed to deduct the wages as an ordinary business expense.

Key Factors the IRS Considers

• Wages must be paid for services rendered in a trade or business
• Compensation must be reasonable for the work performed
• The age of the child and the nature of the services are relevant
• Payments must reflect a true employer-employee relationship, not a personal allowance
• Parents must be able to substantiate the legitimacy, reasonableness, and business purpose of the compensation

Conclusion

Starting a Roth IRA for a child can be a powerful long-term planning strategy, but eligibility depends entirely on whether the child has bona fide earned income. This is straightforward when a child works for an unrelated employer and receives a paycheck. When parents employ their own children, additional care is required.

If you operate a legitimate business and your child performs real work, such as stocking shelves, assisting customers, or performing administrative tasks, and is paid a reasonable wage, establishing a Roth IRA may be appropriate. However, accounts that appear premature or unsupported by earned income may attract IRS scrutiny.

If your child is too young to work, financial education can still begin early. Using a “practice” Roth IRA example can help children understand the power of compounding and long-term investing, preparing them for responsible saving once they begin earning income.