A ROTH IRA FOR YOUR KIDS? YES, YOU CAN!

Here’s a tax strategy you haven’t heard before: Hire your kids to handle domestic duties and put their pay into a Roth IRA.

For three decades, I have promoted the incredible tax savings available to self-employed individuals who hire their children.

In 2003, you could pay each of your children as much as $7,750. You get to deduct it from your business income (reducing your own income tax, your Medicare tax and, potentially, your Social Security tax) and your children pay zero tax on the income (wiped out by their standard deduction and an IRA contribution). If your children are under age 18, you don’t have to pay any payroll taxes — Social Security, Medicare and unemployment/disability — on them.

But what if you’re not self-employed? Hire your children anyway, and use the proceeds to set up a Roth IRA for each child.

Warning: This has not been tested in the courts yet. I firmly believe it is legal (and morally defensible), as I will explain later. A spokesman for the Internal Revenue Service declined to comment, saying the agency has reviewed neither the case law nor specific instances to pass judgment. Nonetheless, I would not be surprised if the IRS challenges this scenario if the concept gains favor among taxpayers.

Creating That Employer-Employee Relationship

OK, disclaimer aside, here’s how the concept works: You don’t have to be in business to hire someone. For years, the IRS has spent millions of dollars educating American taxpayers that if they hire someone to clean their homes, they have created an employee-employer relationship, and the payments are wages subject to Social Security tax.

Clearly then, you don’t have to have a business to create an employee relationship and for the dollars paid to that employee to constitute wages. So if you hire your child — and document it — it’s compensation income to your child. It’s exactly the kind of compensation income that qualifies for a Roth IRA. Remember that the only way someone can set up an IRA is if they earn income. (There is a provision for a spousal IRA, as the government rightly figures that a work-at-home spouse, is by definition, working.)

Back to the youngsters. Hire your children to clean their rooms, wash the dishes and mow the lawn. These are the chores for which, in the past, you have given them their allowance. But now, actually pay them specifically for what they do. Make it clearly income for services rendered, and actually give them a W-2 at the end of the year.

Pay them at least $3,000 during the year. The reason this is more advantageous than, say, setting up a custodial account in which the money is put into an account for your child, is that the income that’s earned while in the account is taxed later at the child’s marginal tax rate. Similarly, you could give the money to your child as a gift, but any income that’s earned is taxed at the parent’s marginal tax rate until the child is at least 14 years old. So you just can’t save as much as you can with this plan.

Socking Away the Money

Now, let’s see what happens when we convert “allowances” into “compensation.”

First, the children will file tax returns. But, because this is “earned” income, it can be offset by their standard deduction of $4,750 (for 2003), so they won’t owe any taxes. Moreover, if you provide more than half of their support, you can still claim them as a dependent and they still qualify for the exemption on your return.

If the children are under 18, because they are working for their unincorporated parent, no Social Security or Medicare taxes have to be paid. Since they are working for their parents at home, no child labor laws are violated.

Then, take the $3,000 in income and put it in a Roth IRA. All earnings in a Roth IRA are tax-free! So you haven’t saved any taxes on this year’s income, but you've socked away money that your child can take out tax-free several years down the road.

How can you do this? The U.S. Tax Court has validated a parent hiring his 7-year-old son to work for his business and allowed the deduction for reasonable wages paid. So, in a non-business setting, we know we can start with children who are at least 7 years old. (No hiring of infants, please.)

If your child takes the yearly $3,000, from ages 7 through 18, and invests it under the Roth umbrella at 10% per year, compounded monthly, that child will have accumulated about $70,000 by age 18, according to the ReesNet.com Financial Calculator. (That’s 144 monthly deposits, $250 each.) Imagine! That money can then be withdrawn by the child tax-free to pay for a college education. Or to start the business enterprise of his dreams.

Alternatively, if your child leaves all of the money untouched, and contributes nothing after he or she hits 19, by the time the child is 65 (that is, 47 years or 564 months), he or she will have accumulated nearly $7.5 million that can be withdrawn tax-free! (No, you can’t take it back. You’ve set the IRA up in the child’s name, remember?)

If you can’t pay what you owe within 12 months, request an installment plan that you can realistically meet. The IRS takes a harder line on longer payment periods, but the government has granted such requests after investigating the individual circumstances.

Even if you cut those numbers in half, you still have created, for less than $5.50 a day, financial independence for your child!

Trying to Find a Hole

Does it work? You bet. The secret is to convert “gifts” into “compensation” to qualify for the Roth IRA contribution. Unlike other investments, the Roth account grows tax-free.

Is it morally right? I think so. Don’t you feel a fiduciary obligation to do what you can to ensure your children’s financial independence? Currently, the nation’s tax laws allow us, as taxpayers, to do this. If Congress thinks the law is wrong or in error, it can change the law.

I’ve asked several other tax experts to find a hole in my analysis. None has been able to do so. I’m putting my professional reputation on the line for this, because the goal is to reduce your taxes — or, at least, to find ways to increase your income.

The fact that I believe this tax strategy is legal reflects, in part, how complex our nation’s tax law system has become. I have said it before and will say it again: It's time to simplify the tax laws.