IRA Rules for Kids

My children are 4 and 5. Can I start an IRA for each of them?

Unless they are child models or TV performers, probably not. Opening an IRA is a great opportunity for kids to start saving early -- but there's a big "if." They can open an IRA only if they have earned income from a job. Unearned income from a savings account or other investments doesn't count.

For children who qualify, a Roth IRA is almost certainly a better deal than a traditional IRA. Because their income is small, they don't get much of a benefit from tax-deductible contributions to a traditional IRA.

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Teenagers can earn income from a summer job or part-time work at a retail store, restaurant, amusement park or swimming pool. Children too young to work at a regular job can earn money babysitting or mowing lawns.

Kids who babysit and mow lawns won't receive Form W-2s reporting their earnings, so it's important that they keep good records for each job -- date, payment, employer, etc.

The maximum contribution to a Roth IRA is $4,000, so kids can contribute that amount or the amount of their annual earnings, whichever is less. If, for example, a child earns $2,000, he or she can contribute up to $2,000 to an IRA.

If your child spends all the money he earns, you can contribute on his behalf -- as long as you don't exceed the amount of his annual earnings.

Allowance doesn't count

I would like to open Roth IRAs for my grandchildren. Do allowances qualify as earned income if they are received in return for doing chores around the house?

No. The IRS doesn't recognize an allowance as earned income for purposes of opening an IRA.

Employing your children

We own two sole proprietorships. What are your thoughts on the tax advantages of employing our children? We are thinking of setting up a Roth IRA for each of them to shelter more money and save for college.

You can employ your children, and open IRAs on their behalf, as long as you follow a few rules.

Make sure you hire your children to do reasonable work for their age and pay them a reasonable wage. Pay with a check drawn on a business account, and file a Form W-2.

As a sole proprietor, you also get a tax bonus: Social Security taxes aren't due on wages you pay to your own child under age 18.