As the end of the year approaches, you should be asking yourself what tax strategies you might be missing out on. Depending on your situation, there are many different ways to reduce taxes. The best person to ask about this is your tax advisor. It helps, however, if you go into that meeting with specific questions. If you have children, one question you might consider asking is how establishing a Child IRA could help reduce family taxes and whether you’re eligible to take advantage of this underutilized benefit.
Current contribution limits for Child IRAs
A Child IRA is not much different from an IRA you set up for an adult. These vehicles provide opportunities for you to give a gift to your child. For parents who operate businesses, the Child IRA can become a valuable generational wealth transfer tool.
“The contribution limit for 2024 (and 2025) is $7,000 (for both a traditional and Roth IRA),” says Caitlynn Eldridge, owner of Eldridge CPA LLC, Omaha. “A child is allowed an IRA when he/she has taxable earned income. Many high-income families own businesses that employ their children, therefore allowing the parents to pay their children a fair wage for the work provided. That shifts, or moves, the income out of the parents’ bracket and into the child’s bracket (which could potentially be $0 depending on the fair wage amount).”
If you’re not currently employing your children, this is something to plan for in the coming year.
Child IRAs: tax strategy for high-income families
Employing children can offer multiple financial benefits. Not only does this transfer wealth and reduce family taxes, but it also creates a business expense (similar to paying any other employee). This can be especially useful in years when you expect higher revenue, with a Roth Child IRA offering additional advantages.
“In years with fluctuating income, parents who own a business can hire their children to shift income into their lower tax bracket, reducing overall tax liability,” says Rachel Richards, head of product at Gelt in Brooklyn. “Wages paid are deductible for the business and qualify the child to contribute to an IRA. Roth IRA contributions maximize tax-free growth, leveraging the child’s minimal current tax liability, while traditional IRA contributions offer immediate tax relief if the child’s earnings are above the standard deduction. This strategy aligns income shifting with tax-advantaged savings for the family.”
Like others who explore the value of a Child IRA for the first time, the temptation to act aggressively when using it can lead you to errors you’d rather avoid.
Common mistakes when using a Child IRA
Just because you can contribute up to $7,000 doesn’t mean you’re eligible to contribute that amount. This is the reason you should rely on your tax advisor for specific advice regarding how to best use a Child IRA.
“One mistake that can be made is over-contribution because your child can only contribute as much as they earn,” says Arron Bennett, CEO of Bennett Financials in Oak Ridge, Tennessee. “Some parents also assume earned income includes allowances or gifts, which do not qualify. Another pitfall is forgetting about the investments that are placed in the IRA. Here, the aim is long-term growth, so make sure the portfolio is in line with this approach and not too cautious.”
Besides miscalculating a child’s income, another common mistake deals with tricks and traps in the tax law. Not everything is as simple as it seems when your strategy involves your children. A Child IRA can help with this.
“Parents sometimes consider shifting investments that earn income to their children so that the investments will be taxed at the lower tax rate of the child rather than the parent’s tax rate,” says Mark A. Luscombe, principal analyst for Wolters Kluwer Tax & Accounting in Riverwoods, Illinois. “However, the law provides for a Kiddie Tax that potentially taxes the unearned income of the child at the parent’s tax rate. The Kiddie Tax can be somewhat avoided if there are contributions to a Child IRA, which holds the investments. The parents’ contributions to fund a Child IRA do not provide a tax deduction to the parents. Instead, it is considered a gift to the child, which the child then uses to fund the Child IRA.”
What can you do if you don’t own a business? Here, the options for starting a Child IRA range from the typical to the exotic.
Other year-end tax strategies that can be used in conjunction with a Child IRA
Your child doesn’t have to work for you to qualify for a Child IRA. Any job that provides earned income will do. For example, it could be working a few days a week at the local grocery store, or it could be working a few hours a month doing household chores for the elderly neighbor next door. If you’ve got a hobby that you can turn into a side hustle, that venture can also pay your child.
“Child IRAs can act as a vehicle for long-term tax-deferred (or in some cases permanently tax-free) growth,” says Christian Rivera, founder of The Ecommerce Accountants in Boca Raton, Florida. “For families with fluctuating incomes, contributing to a Roth IRA in low-income years can maximize benefits. Additionally, having the child earn income through part-time work or family-owned businesses can create earned income eligible for IRA contributions, establishing a foundation for retirement early on.”
If your child doesn’t earn income, that doesn’t mean you can’t adopt a “variation on a theme” Child IRA. While technically not Child IRAs, these strategies can lead to the same end result as a Child IRA.
Jack Towarnicky, Of Counsel at Koehler in Powell, Ohio, suggests “two options, neither require action prior to year-end: 1) Most children do not have qualifying income. So, a parent can effectively gift a Child Roth IRA by opening up a Roth IRA and naming the child as the sole beneficiary; and 2) The parent can open up a 529 account and can contribute up to $18,000 without triggering gift taxes or affecting estate taxes, contributing enough such that the account will be sufficient to fund $35,000 of Roth IRA contributions over a five year period 15 years from now.”
The 529-to-Roth Child IRA conversion became effective earlier this year. This link takes you to an article that explains how to use it to turn your teen into a middle-class millionaire.
Who can I talk to about a Child IRA?
Do any of these options interest you? Take a moment to decide which works best for you, given your situation. Then schedule a meeting with your tax advisor and ask how you can use a Child IRA to reduce family taxes.
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