Originally published on Forbes.com.
Have you funded your kid’s Roth IRA yet? There is still time. Don’t wait till April 15th, though. Avoid the rush and make it happen this week.
If you have a Millennial child in his or her twenties, there is a decent chance that he or she is not earning a lot of money. Thanks to our progressive tax system, there is no immediate concern about income tax. The omnipresent gig economy might mean there is self-employment tax to be paid.
To avoid my struggling with pronouns, let’s call our twenty-something Millennial Terry. Terry is 24 with a bachelor’s degree in media, entertainment, and film technology. The YouTube channel focusing on the early days of Marvel characters – Was Percival Pinkerton, the British commando in Nick Fury’s squad, who went into battle carrying an umbrella really gay? – has, inexplicably, not taken off yet, so Terry’s income is a net of $7,000 driving for Uber. If there is a parent or grandparent in the mix who is reasonably prosperous, $5,500 into a Roth IRA for Terry is a great idea.
A Cheer And A Half For The Roth IRA
A Roth IRA, unlike a regular IRA, does not create an immediate tax deduction. Like a regular IRA the earnings inside the Roth IRA are not subject to tax, unless you get fancy and trigger the unrelated business tax. If you are sticking with conventional investments, UBTI will not come up. The big advantage of the Roth is that qualified withdrawals of both the original contributions and the earnings are exempt.
I have never been a big fan of Roth IRAs. I remember when the notion of converting your regular IRAs to Roth was all the rage. Proponents of the notion prepared projections showing that the plan would make your great-grandchildren billionaires or something like that. The main flaw I noted for ordinary mortals was that in order for the projections to work out you had to pay the tax from the deemed IRA distribution with money that did not come from the IRA. A lot of moderately prosperous persons like myself have almost all their net worth in some combination of qualified plans and home equity.
Also, due to my background, my planning has always been more about avoiding poverty rather than achieving great wealth. I always figured that if I had to be tapping my IRA early it would be the result of some sort of disaster where income taxes would not be much of an issue. I always thought a lot of the Roth believers were overly sanguine about their future prospects. I preferred the immediate tax benefit. In my mind, a person subject to income tax funding a Roth IRA rather than a deductible one is like the guy who hits his head against the wall, because it feels so good when he stops.
An underemployed Millennial like Terry is a different story. Terry is part of Mitt Romney’s famous 47%. Terry pays no income tax. A deductible IRA for Terry would be silly, since it is effectively manufacturing future taxable income. The Roth on the other hand means decades of tax free accumulation.
And The Credit
Even if Terry has some income tax liability, as much as $2,000 into a Roth, can make sense thanks to the savers credit, which applies to people with adjusted gross income up to $31,000. In order to do precise planning on this you need pretty good software.
The Cons
When you fund your kid’s IRA, you are making a gift, which reduces that amount of the annual exclusion that you might have used to make even better gifts – like a discounted interest in a family limited partnership. Unlike a gift to a Crummey trust, where you just tell Terry to sign something and forget about it, the Roth IRA is Terry’s. That might turn out to be a bad thing for a variety of reasons, that are pretty much beyond the scope of this short post. My inner curmudgeon can probably come up with a lot of reasons why this could be a bad idea depending on Terry. So if you have a gut feeling that this is not something you should do, then don’t do it.
Don’t forget that the limit is the lesser of Terry’s earnings or $5,500. Over-funding an IRA has unpleasant consequences.
Is Everybody Doing This?
What inspired me to write this is that after doing my son’s return, it occurred to me that I could fund a Roth for him. In my gut I knew it was not an original idea, and my general tax blogging philosophy is to not post unless I am adding to something to the conversation. I spoke to my friend Jeff Kristoff of Rosen Associates. Rosen Associates has over 700 dental practices in its client base. The Roth IRA for kids is part of their standard repertoire with the added wrinkle of, when appropriate, finding things that youngsters can do around the office. The idea works not just for twenty-somethings but even for tweens. I found this story by Natali Morris who pays her three year old and five year old for doing things like putting stamps on mailers and shredding. That might be getting a little carried away. Also I would explore potential impact on financial aid, before doing this for kids not yet through college.
Rosen Associates is the type of full service firm that will not miss a trick, so I’m not sure to what extent other practitioners are recommending this. It helps if Terry and Terry’s dad have the same tax preparer. Joe Kristan, who does the best summary of what is going on in the tax blogosphere, wrote me that he recommends it, but that he believes it is underutilized. (Full disclosure. I have consulted for Rosen Assocaites, which spun out of a practice that I was part of.)
Will Your Millennial Appreciate It?
I asked my son, William, to comment on my act of paternalism. I expected something like – “It is not as exciting as the time he got me an X-box so I could play Animal Crossing, but I’ll probably appreciate it when I get old like he is.” Instead I got – “It’s funny that he thinks I’ll be able to pay much into it in this economy.” Of course, that was why I funded it.
Note On Deadlines And Other Matters
You can get the fine points on IRAs from IRS Publication 590. The due date for making a contribution is the due date of the return for the year the contribution applies to, so you actually have till April 18th this year. I have seen at least one sponsor stating that the plan has to be open by April 15th. My practice is to not focus with that sort of precision on deadlines preferring to get things done a week or two early. Roth contributions are not reported on your tax return, so Terry’s grandmother can make the contribution even though Terry has already filed without having to amend Terry’s return.
One important point is that how you or I interpret the rules is of little significance if your plan sponsor looks at it differently.
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