Giving Your Kids (or Grandkids) an Earned Income & IRA Contributions

Did you know that you can set up a Traditional or Roth IRA in your child’s name (or even in your grandchild’s name)? You can also do the same with education savings accounts (ESAs) and health savings accounts (HSAs). Many investors utilize this strategy to build their family’s legacy, while setting up their kids or grandkids for future financial success.

So, how does this strategy work, and what are the rules?

Earned Income

First and foremost, to set up an IRA, the child must have an earned income for real work completed. It’s more common to hire your child or grandchild for your business if they are at least 7-8 years old, as they are more capable. For example, they could help with administrative work, such as collecting rent checks by opening the mail, addressing envelopes, entering data into an excel spreadsheet, cleaning up your desktop, or even downloading apps for you.

Be sure to pay them by the hour and keep a log of when and for how long they worked for you. If the IRS has any questions, you will be able to share the logs showing which Saturdays, after school, or which days in the summer they worked.

If they’re younger than 7 years old, you may be able to hire them as a model. For example, one of the biggest benefits of real estate investing is passive income, which enables you to spend more time with your family, because you are essentially making money while you sleep. This is a benefit that I cherish, and so I have several pictures of me spending time with my grandchildren that I like to include in presentations, social media, or even on my company’s website. It’s important that you do research into the local acting agency’s rates and pay your children or grandchildren a fair wage.

Tax Liability

When the child has an earned income, they are required to file a tax return. That said, if they make less than $12,000, they won’t be required to pay federal taxes (Note check with your tax professional as this changes from year to year).

Depending on the company’s structure, payments may or may not be required towards social security and Medicare. Let’s say you have a corporation or multi-member LLC and you pay your child or grandchild an earned income from your business. The company would be responsible for paying 7.5% towards social security and Medicare, while the child and grandchild would also need to pay 7.5%.

If you have a single-member LLC or a sole proprietorship, but you pay your child, you would not be required to make payments towards his/her social security or Medicare.

If you paid your daughter $12,000 there would be no federal income tax as of 2020 rules thus aving you the difference between your tax bracket which could be as high as 37.5%. A savings of $4,500 or 37.5% of $12,000.

Whoever makes the payments can deduct them on his/her tax return. To make sure all requirements are being met, I recommend consulting with your CPA or tax advisor.

IRA Contributions

Contribution limits need to be adhered to, of course. The same limits that apply for adults apply for kids. If you have a traditional or Roth IRA set up in their name, a contribution of $6,000 could be made for each tax year that the child makes an earned income.

If you put in as much as you can and get it working (i.e. invest it as soon as possible), you will be able to grow their IRA substantially over time.

For example, If you start an Education Savings Account (ESA) when they are born and contribute $2000/ year and invest it at 10% they will have $80,000 for college or technical school all tax free. Do that for 10 grandkids it equates to $800,000.00 almost a million for education. If possible, think about a Roth Ira going 40 to 50 years with the same return and contribution it would be $2,5 Million- all tax free

Over the years, my strategies have evolved as well. Each of my children are grown and have their own IRAs, but I also want to work with them to grow their wealth. I used to have all four of my children as the beneficiaries on my IRA. But instead of leaving it that way, I moved Roth money and to four new Roth IRAs. The beneficiary for the original one is now my wife, but each of my children is the sole beneficiary of one of my new Roth IRAs. As such, each of them can work with me to grow the money in that account, and I still have immediate access to the tax free money.

By helping find deals and build the account, my kids learn more than they would if I just handed the money to them. As the proverb goes, “If you give a man a fish, you feed him for a day. If you teach him to fish, you feed him for a lifetime.”

Regardless of how the account is set up or which account type you choose, it’s important to involve your child (or grandchild) in the process. Take advantage of teaching moments. If they’re older and you’re working on a deal together, it may be easier for them to learn through experience. If they’re young and helping you with administrative duties, you can still teach them about basic concepts. For example, if they’re opening the mail that includes rent checks, you can discuss the benefits of passive income, or in other words “mailbox money.”

No matter how you choose to pass down your investing knowledge to your children (or grandchildren), getting them started early will help set them up for future financial success. That said, it’s never too late! If you haven’t started yet, today is as good a day as any.