Should You Max Out Your Children’s Roth IRA with Daniel Wrenne

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In this episode, we explore a critical financial question that often surfaces in the world of family finance: Is it a smart move to maximize contributions to a Roth IRA for your children? Host Daniel Wrenne, a seasoned financial advisor specializing in working with physicians, delves deep into this intriguing topic in a thought-provoking episode.

In this conversation, Daniel unravels the complexities of funding Roth IRAs for your children and sheds light on the potential pitfalls and benefits of this financial strategy. The episode covers a range of essential aspects, including:

  • The critical rules and regulations governing Roth IRAs for children, ensuring you stay on the right side of the IRS.
  • The difference between employee and independent contractor compensation, and how it can impact both parents and children.
  • The paramount importance of evaluating your child’s financial responsibility and literacy, and how this impacts their readiness for managing a Roth IRA.
  • The tax implications and benefits of this strategy, especially for self-employed individuals.

Don’t miss this enlightening discussion that goes beyond the numbers, emphasizing the significance of preparing your child for a financially secure future. Whether you’re a parent considering funding Roth IRAs or simply intrigued by the world of family finance, this episode provides invaluable insights to help you make informed decisions.

Tune in to the Finance for Physicians podcast to explore these essential considerations and ensure your child’s financial journey is set on the right course. 

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Full Episode Transcript:

 Daniel Wrenne: Hey guys, hope you’re having a great day today. I’m going to be talking about. A big question that comes up often in our work with families, and that is whether or not it makes sense to max out a Roth IRA for your children. I’m sure you’ve probably thought about funding Roth IRAs for yourself, and maybe you’re already even doing this, but today we’re going to be talking about whether or not that makes sense to Help your children to fund a lot of times it seems to come up, uh, from friends or maybe you read about it on a, on a blog post or hear a podcast where they talk about it.

And in my experience, a lot of times what people talk about or what you hear about are the numbers. Now the numbers do make a lot of sense. There’s a lot of, uh, appeal to the tax benefits associated with this. It’s a great tax shelter. And on the surface, it definitely does make a lot of sense, but. I think there’s a lot of concerns also that come into play, and I think it’s best to proceed with caution.

So we’re going to be talking about some of the good things, but we’re also going to be talking about some of the potential negatives to consider. I think it’s important to look at both sides so that you can make an educated decision. And ideally that’s the right approach. as I mentioned, the numbers look really good, but there are several big factors to look at before you get into the numbers.

So I’m going to talk about the numbers at the end, but one of the, what I wanted to go through first was a couple of these other big factors. So the first big factor are the rules. So the rules, you have to make sure you’re following the rules. This is. One of the most common problems I see when we encounter like a family that’s already funding a Roth IRA for their kids, or maybe it’s a client that we start working with in our planning firm that their parents funded a Roth IRA for them.

I think the number one problem we see is that they were not exactly following the rules. And so that’s, that’s a, you want to avoid, breaking these rules that exists with the IRS. because if, you’re breaking the rules, that’s, that’s just going to add more stress and if you get audited, it’s going to cause lots, lots of problems and it’ll defeat the whole purpose in the first place.

So first rule to think about is you can only fund a Roth IRA for your children up to the level of income that they earned in the particular year. So you can’t go above that level. I’ve seen that happen a lot where people say, you know, I’m funding a Roth IRA for my child and it’s like. Well, what’s their income?

None. Okay. Well, you’re breaking the rules. That’s you’re not following the rules there. So you have to, you can only fund a Roth IRA up to the level of income that you’ve earned in a given year. And of course you can’t go above the max for the IRA as well. so they have to be earning money first and foremost, and the money that they’re earning has to be legitimate.

Like it has to be like a legitimate job and the compensation has to be reasonable. Basically they have to be doing work, at a level that you would pay someone else, like you have to be paying them at a level or they have to be earning at a level that anybody else would earn at for the work that they’re doing.

So that makes it like a reasonable from the IRS standpoint. And I think this is especially important, like these rules I’m talking about become especially important if you happen to be the ones paying them. and in particular, if you have a business, because you’re on the hook for making sure you’re following all these rules, it’s important to make sure they’re not breaking the rules, but as a business owner or, you know, as a parent paying them, you also have rules you need to follow.

So if you’re the employer, on top of making sure, you know, that their income is legitimate and that their compensation is reasonable and that they’re funding the correct amount, based on that, you also have to handle the legal requirements of like. Whether they’re an employee or however, you’re compensating them.

So for example, you know, W four is a form you have to file for employees. I nine is one, you got to have an EIN, you got to send your child. If they’re employed W twos each year, make sure all the appropriate taxes are paid. Um, there’s a, there’s a list of requirements. You’re going to have to handle if you’re the employer paying your child.

Now they’re a little bit less rigorous if you’re hiring them as an independent contractor, we’ll talk a little bit more about that in just a second, but. In that setup, there’s also typically a little bit more tax associated with this. So tax wise, it’s typically a little better to have them be an employee.

and, so that’s, but on the flip side, when they’re an employee, there’s more administrative burden for the employer. So rules are really important. You got to make sure you’re following those IRS rules. They can’t fund until they have income and you can’t fund more than the income. So you can only fund up to the income or the IRS limits for the IRA.

your child’s work that they’re doing has to be legitimate or reasonable. Compensation has to be reasonable. And if you’re the one paying them, especially if you have a business, you have to make sure you’re, handling all the legal requirements. checking all the boxes. so those are the big rules to think about. the second thing I’ll throw out is how you’re going to be compensating them or how they will be compensated. So, I already mentioned this a little bit, but there’s the two common ways are either employee or independent contractor, and it should depend on the work that they’re actually doing.

It’s not something you’re supposed to be able to just decide. It’s, it’s more based on the actual work and the engagement and the responsibility. So if you’re a business owner hiring them, you definitely want to talk to your accountant and get their advice on all this stuff. Really, it’s good to get your accountant’s advice on all this either way, but especially if you’re a business owner, employing them.

And then when you talk to, to your accountant, I think it’s, it’s going to be good to, to ask them about specifically like whether or not they should be considered an employee or an independent contractor. Now, like I said, already, I think I implied this earlier, like the employment setup typically has a slightly better tax benefit and that’s because your kids.

Don’t have to pay, social security or Medicare tax. you don’t as the employer as well, but you have to make sure that they’re working in the correct way to be qualified as an employee. Now, independent contractor, that’s a different setup. like I said, there’s a little bit more tax implications typically.

and that’s because they in most cases have to pay social security and Medicare. but as the employer, the admin requirements are a little simpler. So like I said, talk to your accountant about the specifics of this. Um, now if you’re not the business owner hiring them or say, they’re just going to be working for someone else.

And they’re going to be an independent contractor, especially, I would also throw out is you need to be thinking about making sure you’re keeping all their income records and expense records so that you can report it correctly on their taxes. So going back to the first rule, like in order for them to fund a Roth IRA, they have to have a tax return filed and have to show income up to the level.

Of the amount they funded. And so you’re going to have to be having numbers ready to file a tax return at the end of the year. Or at the beginning of the next year. And so it’s best to just kind of keep up with that along the way, even if they’re getting paid cash, you can create a spreadsheet and, document each, income and then where it came from and if there happens to be expenses, like what it was and where, what it was spent on

types of compensation are important to consider. Like you thinking about independent contractor versus employment. Employment is a lot simpler, for the employee, but a lot more administrative burden for the employer. Whereas independent contractor is going to be pretty straightforward and simple for the.

Employer, or I guess the entity paying them, but you’re going to have to make sure and keep up with records, as the, you know, parent of the child so that when you do taxes, it’s, you have the correct numbers. Whereas if they’re an employee, you just get a W 2 and it’s pretty straightforward. The next thing I wanted to talk about that I think is probably the most important thing.

well, you know, following the rules are important. You got to do that. But I think this is just really important. And I think it’s people kind of gloss over this, but what I wanted to talk about next is. Your child’s responsibility and financial literacy. So I would think about like the questions, like how financially responsible is my child today?

And if I was to predict the future, like how, how financially responsible or just responsible in general, do I think they’re going to be when they’re older, like 18, 19, 20. And then how financially literate is your child today? What about when they’re a little older, like early adulthood? I think this is super important.

Primarily because money is kind of like an amplifier. And so hopefully your child is like on a good track and has a lot of responsibility and experience and literacy financially. And so money is really just going to allow them to be a better version of what they already were. But if they’re still kind of getting their bearings on things, or maybe they don’t have any experience, And they’re not financially literate, don’t have a lot of responsibility.

Money’s just going to make things worse. So I don’t think money in itself makes you into a great person. It can amplify kind of. whoever you already are as a person. And so I think it’s important to really think about these before you start to build up a large raw thyroid for your kids at a young age.

So like to look at this from the extremes. Like most of the time people are somewhere in the middle, but I think it’s helpful to look at the extremes. So let’s say, hopefully in your scenario. you’ve been teaching your child financial literacy. Hopefully they’re developing responsibility in particular fiscal responsibility and.

even say they’re 10 years old and you’ve already started teaching them about money. They’ve already been experiencing what money does, how it works, how to make mistakes, they’re making mistakes. and you’ve been intentional about helping them experience finances themselves.

You’re not just doing everything for them. you’ve resisted that temptation. I mean, it’s tempting as a parent to like do things for your kid or just kind of like shortcut it. you know, hopefully you’re allowing them to make those mistakes. So they get into the teen years and, you know, maybe they get through that without developing any bad habits, any serious bad habits.

Everybody makes mistakes, but, maybe they’re transitioning into adulthood. And as far as you can tell, they’re on really solid track to make solid financial decisions. even at that young age, or at least like talk to you for advice before they make big moves. I think this is a prime. Situation like if this is going to pan out like this, like the Roth IRA is fantastic because it can give your child like a leg up and a headstart and it really can even be a vehicle to teach them and allow them to experience, managing finances and see what it’s like to put their hard earned money to work.

Hopefully they’ve. Learned the lessons of like what hard work is that I think helps with all this as well Like if they’ve put in the hard work to earn the money themselves and that goes back to what we were talking about before like Legitimate like if they’re legitimately working that teaches them the benefit of hard work and they And then they’re also learning the benefits of compound interest and growing in a Roth IRA.

And then they’ve developed some good habits and they’re becoming an adult. That’s, you know, that’s a good position to be able to transition this to them and not, put them in a worse spot and maybe even help them quite a bit because that’s at the end of the day. I know that’s what, we, as parents want to do.

On the other hand, so we’ll paint the picture with, the other extreme of not a great scenario. So let’s say, instead of teaching them fiscal responsibility and financial literacy, you’re pretty much doing everything for them. so they, they haven’t really experienced anything in terms of managing finances or.

Or taking responsibility for them, things themselves, as a child. and how would they, if you’re doing it all for them? so maybe you’ve, taken a proactive step to max out Roth IRAs for them every year, from your business, but maybe they’re not actually working any. So at best it’s questionable.

So they’re not really learning that lesson of hard work. maybe they don’t even know that they’re funding a Roth IRA. they definitely don’t look at the statements that they haven’t learned much about how it works or what, you know, compound interest is. so in the early years, it’s not a big deal.

Like everything’s going fine and they’re, you know, getting through childhood, but when they start to reach like the teen years or like 16, 17, 18, maybe they make a few bad decisions. And develop some bad habits, like a lot of us did, like everybody’s going to make bad decisions. but they’re experiencing some of these things and haven’t developed a responsibility yet.

And, you know, when you don’t have that responsibility muscle developed, you’re prone to bad habits. So in this situation, so maybe they have like alcohol abuse or, you know, drug addiction or something like that. Like that’s, that’s a worst case scenario. And none of us want that to happen. but when, if you’ve been building up this Roth IRA and you add that to the mix, it’s going to be, throwing gasoline on the fire.

It’s not going to help them. It’s going to make things worse. Now, I know that financial responsibility doesn’t directly translate to responsibility in general, but I do think that there’s some overlap. You know, responsibility in general, typically people that are responsible are also oftentimes fiscally responsible.

So I think more money, adding more money to the mix in this situation can put your children in a worse position than they were otherwise. I’ve come across people that have, you know, gotten into this situation where they are worried about what’s going to happen when their child like gets access to their Roth IRA, because they know that they’re going to blow it on potentially dumb stuff and, you know, or to, to fund their bad habits. So I think I mentioned this because I think it’s really important to think about that. Like. When you’re thinking about funding a Roth IRA, it’s important to think about what your future looks like for your child and how it ties into their own responsibility and literacy.

And I think the, the sooner you think about that, the better. You can also like help them to get to a point of, of, you know, being responsible and, and, and gaining that literacy as you build it up. but we just want to avoid, I mean. as a parent myself, like, I don’t ever want to put my kid in a position where, you know, they might be worse off because of something I did.

So I think, like I said, it’s not a direct translation to responsibility, overall and fiscal responsibility. And there is also this layer of like. Uncertainty, like some parents do a fantastic job, teaching their children responsibility and good habits and, teaching them about finances and all they, they do all the things and just things don’t go as planned and their child has make some bad decisions or ends up in the wrong circles and, They can have some problems. So there is that uncertainty that goes along with this whole strategy as well. That you got to think about, like, sometimes it just, things don’t go as planned and you want to be, you, you want to ideally not be in a position where you’re making things worse because of the unfortunate circumstances.

so I wanted to throw all that out there. I think, you know, if you’ve thought through all those things and you’re being proactive about avoiding that bad scenario. And you’re comfortable with the uncertainty of, you never know what’s going to happen. I think it’s a great thing to fund or at least think about funding.

so I’m going to wrap up with throwing out some of the numbers to think about. The numbers look really good. I didn’t want to leave with that. Cause it’s like everybody will want to do it. but the numbers you know, really look solid. especially if you’re self employed and you’re. Employing your children.

Okay. So the best situation, like I said, for maximizing the tax benefits for your child is when you’re a business owner or self employed and you’re the one that’s employing them and it’s best if you can pay them as a W2 employee, for, for tax purposes, as long as they qualify. And so when you do that, if you, as you pay them, you get a business deduction for whatever, compensation they receive.

So if you’re a high income earner, that’s going to be a big tax savings for you, the business owner, like, you know, maybe 40 percent or even higher. And so when you’re employing your child, on top of that, neither you nor your child have to pay social security or Medicare taxes. so that’s, that’s a really good deal on top of saving on, the taxes yourself.

So between you and your child, that Medicare and social security tax totals up to a little over 15%. So you can avoid that when you’re employing a child. and then on top of all this, if your child is earning less than 13, 850, and that’s for 2023 tax numbers, this’ll change every year based on the standard deduction.

But if your child’s earning less than 13, 850, they’re not going to have to pay any federal income taxes. and so state and local taxes can sometimes be, um, do, but that’ll depend totally on your location. So basically you’re able to get a really good tax deduction. or a business expense, on the money you pay them.

So it’s like, it’s almost like pre tax like, or tax deductible on the money you pay them. And then your kids more than likely shouldn’t be paying any tax themselves. So it’s pre tax. Because it’s a business expense and then your tax, your kids get it tax free if they’re below threshold. And then if they can put it into a Roth IRA, that is also tax free, and grows tax free.

That’s a home run. It’s like no tax on all levels. So it’s a, it’s a really good deal. and it. You know, throw some compound interest on top of that. It’s a home run, but I think I would, I really think it’s important to emphasize like, of course you got to follow the rules. that’s important. You got to do that.

But like this whole fiscal responsibility and financial literacy is huge. I think you have to really think about that for your children and making sure that you’ve checked those boxes or at least thought about it before you start doing it. So, that is, those are the big points to think about when you’re considering funding Roth IRA for children.

There’s a bunch of topics like this that I can cover around helping your children get started saving. if you want, if you want us to go that direction, please let me know. I’d love to talk about it. I hope this was helpful and as always, we will look forward to seeing you next time.