CARL WATTS & ASSOCIATES

September 02, 2013

www.carlwatts.com
office@carlwatts.com
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Individual Retirement Accounts are very popular instruments for retirement financial planning. But, isn’t it a little too early for a child to consider one of them?

As a matter of fact, there’s no age limit for starting an IRA, be it either a traditional IRA or a Roth IRA, as long as your kid has earned income.

A child’s earned income means money from a part-time work, a summer job, from babysitting or mowing lawns, but it does not include allowance, income from a savings account or other investments.



Of course, kids who babysit and mow lawns won't receive Forms W-2s or 1099-Misc reporting their earnings, so it's important that they keep good records for each job -- date, payment, employer, etc.

So, what kind of IRAs are suitable for a child? It will have to be either a traditional IRA or a Roth IRA.


As you know, a traditional IRA is tax-deferred, meaning the contribution you make each year is tax deductible and you will have to pay income tax on the distributions only. But that is not that important for a child who’s income is more than probably not taxable anyway.


On the other hand, a Roth IRA contribution is not tax deductible, but distributions are, and these accounts are known to be more flexible.

Therefore, it is really up to you what kind of IRA you want to open for your child, and bear in mind that you would be the account custodian until the coming-of-age of your child.


For year 2013 contributions are limited for all traditional or Roth IRAs at a maximum of $5,500 or your taxable compensation for the year, whichever is smaller.


Of course, children can only contribute as much as they earn.

It is very likely that any child would rather use their first hard earned pay for almost anything else other than a retirement account, but if you can afford to, you can contribute to the account yourself so the child can buy the bicycle they’ve been dreaming of, for instance. Nobody can tell which money went where, as long as the contribution is within the amount of the child’s earned income.

Other than the benefit of having a large retirement account after the age of 59½ , there are two other main advantages for opening an early IRA for your child.

Generally, if you take a distribution from your IRA before you reach age 59½, you must pay a 10% additional tax on the early distribution. This applies to any IRA you own, whether it is a traditional IRA or a Roth IRA.

However, your child can take distributions from their IRAs for qualified higher education expenses without having to pay the 10% additional tax. They may owe income tax on at least part of the amount distributed, but they may not have to pay the 10% additional tax.

Generally, if the taxable part of the distribution is less than or equal to the adjusted qualified education expenses (AQEE), none of the distribution is subject to the additional tax. If the taxable part of the distribution is more than the AQEE, only the excess is subject to the additional tax.

For purposes of the 10% additional tax, these expenses are tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance.
Your Kid's IRA
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In addition, if the student is at least a half-time student, room and board are qualified education expenses.

The expense for room and board qualifies only to the extent that it is not more than the greater of the following two amounts:

  1. The allowance for room and board, as determined by the eligible educational institution, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.

  2. The actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.

You will need to contact the eligible educational institution for qualified room and board costs.

When determining the amount of the distribution that is not subject to the 10% additional tax, include qualified higher education expenses paid with any of the following funds: payment for services, such as wages, a loan, a gift, an inheritance given to either the student or the individual making the withdrawal, or a withdrawal from personal savings (including savings from a qualified tuition program (QTP).


An eligible educational institution is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The educational institution should be able to tell you if it is an eligible educational institution.

Certain educational institutions located outside the United States also participate in the U.S. Department of Education's Federal Student Aid (FSA) programs.


By January 31, the payer of your IRA distribution should send you Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. The information on this form will help you determine how much of your distribution is taxable for income tax purposes and how much is subject to the 10% additional tax.

If you received an early distribution from your IRA, you must report the taxable earnings on Form 1040, line 15b (Form 1040NR, line 16b). Then, if you qualify for an exception for qualified higher education expenses, you must file Form 5329 to show how much, if any, of your early distribution is subject to the 10% additional tax. See the Instructions for Form 5329, Part I, for help in completing the form and entering the results on Form 1040 or 1040NR.

Another way your child can use an IRA early distribution without having to pay the 10% additional tax, is to take up to $10,000 of distributions to buy, build, or rebuild a first home. To qualify for treatment as a first-time homebuyer distribution, the distribution must meet all the following requirements:

  • It must be used to pay qualified acquisition costs (costs of buying, building, or rebuilding a home, and any usual or reasonable settlement, financing, or other closing costs) before the close of the 120th day after the day you received it;

  • It must be used to pay qualified acquisition costs for the main home of a first-time homebuyer;

  • When added to all your prior qualified first-time homebuyer distributions, if any, total qualifying distributions cannot be more than $10,000.

With all the advantages mentioned above, there come numerous rules and regulations regarding how traditional and Roth IRAs work and a professional’s opinion will always be your best option, no matter whether it is for your own investments or your child’s future financial planning.