Contributing to a child's IRA.

• Author: Ellentuck, Albert B.
• Position: Individual retirement account

ESTABLISHING AN INDIVIDUAL RETIREMENT account (IRA) in a child's name can be an effective planning technique for a child with earned income. An IRA can enable a child to shelter investment (portfolio) income from taxes (if a traditional IRA is used) and establish a retirement fund that can take advantage of many years of taxdeferred growth.

The usual IRA rules and limitations apply. Thus, for 2012 a child must have legitimate self-employment or wage/salary income, and the annual IRA contribution cannot exceed the lesser of $5,000 or 100% of earned income (Sec. 219(b) (1)). The IRA account must be established and funded by the original due date of the return, excluding extensions. The rules barring a Roth IRA contribution or deduction for a traditional IRA contribution (i.e., participation in an employer-sponsored plan and modified adjusted gross income in excess of a certain threshold) apply to a child but will normally not be a factor. Thus, a child's contribution to a traditional IRA (vs. a Roth IRA) will generally be fully deductible.

The key to contributing to an IRA is that the child receive earned income. For a child, earned income can come from a variety of sources, including part-time jobs, summer jobs, or activities such as baby-sitting, lawn mowing, or paper routes. Working in a family business is convenient and provides flexibility, but as in all cases in which a child is employed by his or her parent(s) or an entity controlled by the parent(s), the IRS can be expected to scrutinize carefully whether the income was in fact earned, and at a reasonable hourly rate for the work actually performed.

Traditional IRA Shelters Child's Portfolio Income

Clients are often frustrated when their children must pay income tax on what seems like a relatively small income. This is particularly common for parents who have saved for a child's college education using a Uniform Gifts/Transfers to Minors Act (UGMA/UTMA) or similar account. The disallowance of a personal exemption deduction because the child can be claimed as a dependent on his or her parents' return, and an often reduced standard deduction, are normally the main causes children incur a tax liability.

Example 1: Assume that F and M are in the 25% tax bracket and recently began saving for their 15-year-old daughter D's college expenses by regularly putting aside funds in an UGMA account in her name. In 2012, these funds produced $2,200 of interest income. Also in 2012, D earned $2,050...