savings

Fund a Roth IRA for Your Grandkid

If your grandchildren have earned income, you can contribute to their retirement accounts.

EDITOR'S NOTE: This article was originally published in the August 2009 issue of Kiplinger's Retirement Report and has been updated in January 2010. To subscribe, click here.

Perhaps your 12-year-old granddaughter earns money babysitting for the neighbor's children. You can help her open a Roth IRA. She can put her earnings into the Roth -- or she can keep the cash and you can make contributions for her. Thanks to the power of compounded returns, she'll be thinking of you with great affection when she retires.

To help your grandkids build a nest egg with a Roth IRA, they need earned income, whether it's money from raking leaves or a stint as a lifeguard. "Roth IRAs can be a fabulous tax-free growth opportunity for grandchildren because they are investing early and investing young," says James Lange, author of Retire Secure!: Pay Taxes Later (Wiley, $25).

Indeed, those early contributions can pay off big time, says Mark Haug, a teaching fellow at the University of Kansas's business school. According to a study by Haug and co-author Adrienne Cichelli, a child who contributes $500 a year for just nine years from the ages of 10 to 18 will accumulate $111,982 by the time he reaches 60, assuming an average annual return of 7.2%. That compares with $97,084 for a Roth IRA owner who contributes $500 a year from the ages of 22 to 59. If the 10-year-old continues to contribute $500 until 59, he will have a nest egg of $233,308 at age 60.

If you doubt that a youngster would see the wisdom of locking away his or her earnings for decades, don't worry. "If your 10-year-old grandson opens a lemonade stand and clears $300 for the summer, the kid could keep the money and Grandma can tuck $300 in the Roth," Haug says. Contributions to a Roth IRA can't exceed the child's earnings for the year, up to a maximum of $5,000 in 2009 and in 2010.

Create a Paper Trail

In the unlikely event that the IRS questions the contributions, you should help your grandchild keep records of hours worked and wages received. The proof is easy if the income is reported on a Form W-2 from an employer, such as a pizza place or car wash.

Things get more complex if kids work in less-formal jobs, such as babysitting or leaf raking. You need to be especially careful if you hire a grandchild to do odd jobs around your house. Paying for lawn mowing will likely pass muster with the IRS, as long as you pay a reasonable wage. You'll have a stronger case if he or she also gets paid for cutting grass for other people.

It's doubtful that your grandchild will be on the hook for income taxes. Children who work as employees generally don't need to file a tax return unless their income exceeds the standard deduction amount, which is $5,700 in 2009 and in 2010.

But a child who has net earnings of $400 or more from self-employment must file a tax return to pay the 15.3% tax for Social Security and Medicare. Carol Topp, a certified public accountant in Cincinnati, says figuring out whether a teen is self-employed can be tricky. She says that a child under age 18 who is a household employee, such as a babysitter, is not considered self-employed. A child who mows lawns for neighbors would be an exempt household employee, but he would be considered self-employed if he mows grass for local businesses.

Even if a child doesn't owe any taxes, Topp recommends that the child file a tax return. "I have never heard of an audit for a Roth IRA, but filing a return would create a paper trail," she says. Roth contributions are not reported on returns, but the form would establish that the child had earned income.

You'll need to shop around for a financial institution that will allow an adult to open an account in a youngster's name. Diane Young, director of retirement and goal planning for TD Ameritrade, says most custodial Roth IRAs at her brokerage firm have been opened in the past couple of years. "People are catching on that they are doing their children and grandchildren a favor by helping them save for retirement," she says. Other firms that offer this option include Charles Schwab, E*Trade, OptionsExpress, Scottrade and Vanguard.

For more authoritative guidance on retirement investing, slashing taxes and getting the best health care, click here for a FREE sample issue of Kiplinger's Retirement Report.

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