Most people are aware that Roth IRAs enable after-tax contributions to grow income tax-deferred. Moreover, provided that certain conditions are met, distributions of not only contributions—but also investment growth—of a Roth IRA can be taken income-free provided that you’ve owned the IRA for at least 5 years. The five-year period begins on Jan. 1 of the year you made your first contribution to your Roth. Once that 5-year period tolls, earnings can only be withdrawn income tax-free if taken after age 59½ unless you qualify for certain exceptions. To be clear, however, if you’ve had your Roth for less than five years, there are also exceptions that can exonerate you from the 10% penalty on withdrawn earnings — but not all income taxes (see below for more detail).
With the exception of a spousal IRA, one must have earned income in order to be able to contribute to a Roth IRA. As such, when you employ a child who is under 18 in a family business, a Roth IRA contribution equal to the lesser of their total compensation or the $6,000 contribution limit can be made for that income tax year. I use the phrase can be made in the context of discussing the contribution because the actual dollars contributed to the IRA don’t necessarily have to come from the child. For example, the contribution to the child’s Roth (with a parent as custodian until the child reaches the age of majority) could be made by a parent or grandparent. Of course, this contribution would constitute a gift from the parent/grandparent. However, as long as the sum of all gifts to that child during the calendar year, including the funds contributed to the child’s Roth, don’t total more than $15,000—the annual gift tax exclusion amount for 2020—the gift need not be reported by the donor.
Although the Roth can be a powerful way to take advantage of compounding tax-free growth until the child reaches age 59.5 and can withdraw investment earnings (by contrast, contributions can always be withdrawn income-tax fee) without penalty or income tax, there are a few ways in which withdrawals can be taken where either the 10% penalty (solely) or income taxes and the penalty (together) can be avoided:
- Qualified College Education Expenses-tuition, fees, books, supplies and most room and board expenses). Earnings are taxed upon withdrawal but there is no 10% penalty on those earnings;
- After a 5 year wait, the child can withdraw up to $10,000 in investment earnings for the purchase of a first home both penalty and income tax-free.
The confluence of a broad menu of investment choices and income tax-free compounding makes the Roth IRA a powerful vehicle to accumulate significant wealth. For example, self-directed Roth IRAs enable the owner/custodian to invest in a broad array of “direct” investments such as real estate, mortgages or other types of promissory notes. Of course, being able to fund that Roth IRA with tax-deductible dollars from a parent who employs a child is an optimal way to combine multiple steps to ultimately utilize a “permanent difference” in the tax code to your family’s advantage.
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