Roth IRA for two-year-old?

[uneven_cyclist]

Greetings all!  My wife and I just cashed out an insurance policy of hers (~$7K) and would like to invest the money for our son, who is currently two years old. 

What would folks think about investing in a Roth IRA? 

Our thought would be to invest this money and perhaps repeat the process two or three more times over the next two or three years and then just stand back and allow the fund to grow tax free.  If we were to contribute, say $24k and then allow that to grow for 15 years or so, then he would be in a great position for going to college.

I love this option for a few reasons:
*Money would grow tax free
*Full flexibility over how and when to withdraw the money
*Money would not adversely affect calculations on FAFSA application when kiddo applies for financial aid.
*If we invest in this way now then we can minimize the amt. of our *own* taxable withdrawals when the time comes for kiddo to go to school (although this would also be the case with a 529, just we would still have the drawback about the fafsa calculation still).

However, I am also wary about it for a few reasons:
*Although my wife and I both do some work online apart from our main careers and could therefore claim that we're training the kiddo to one-day become a part of helping us in these efforts...I do not know if this would be adequate for the IRS?
*I do not know if training counts, or to what extent, etc.
*There are a lot of blog posts about this -- stuff like "Even a baby can have a Roth IRA!" but then when it gets down to the fine print, things become really vague.
*Assuming we were to fail an audit and be out of compliance--and I have no idea if we are?--then I do not really know what the consequences would look like/how much of a hassle we might be faced with.

So, with these things in mind, do folks have any advice/thoughts/recommendations?

I am aware of 529 plans, though by no means an expert, and also have considered simply investing in a taxable account for him. 

We live in a state without a tax deduction for investing in a 529, and so that is not a major consideration for us. 

Thoughts/recommendations?

Thanks all for your time!

[Rob_bob]

You would have to open a custodial account.  Then your child would need to have earned income, not sure what kind of work a two year old could do that the IRS would accept, maybe modeling or child actor.

[nereo]

Child labor laws are pretty strict for children under 5. I would worry about what the IRS would accept as “earnings” for a two year old and consider the legal peril you may be in for making such claims.

To me the future tax savings to my offspring aren’t worth it - just open a normal custodial account, either a 529 or a basic taxable. Your kid can easily have earnings as a tween and start their adult life with a major financial cushion.

[reeshau]

*Money would not adversely affect calculations on FAFSA application when kiddo applies for financial aid.

Generally, if it sounds squirrelly, it is.  If you have strong feelings about your kid going to college, there isn't much difference between a 529 contribution and a Roth.  Except, the 529 is legit for a 2 year old.

Specifically: the quoted statement is not fully correct.  Roth balances do not count on FAFSA, but Roth withdrawals are "untaxed income.'  So it counts, but differently.

[sonofsven]

Unfortunately, only politicians get paid for filling their diapers.
And 2 is a little young to get into politics.

[theolympians]

Yeah, I think one has to have income which could be placed in a retirement account. An infant can't work. The IRS might stretch things for a tween or teen, but an infant is another issue which I wouldn't touch.

[nereo]

Yeah, I think one has to have income which could be placed in a retirement account. An infant can't work. The IRS might stretch things for a tween or teen, but an infant is another issue which I wouldn't touch.

I’m not sure why you said “might stretch things for a … teen” - A 14 year old can work 5 hours a day on non-school days and up to 25 hours per week, so long as the job is not classified as hazardous. At age 16 a child can work a full 8 hour shift, and there’s a variety of companies that will hire them.
What am I missing?

[Michael in ABQ]

The only legitimate source of earned income for a child that young would be something like modeling and acting. And if you tried to claim that you paid your child model $1,000 for a 1-hour photoshoot to model something you're selling on Etsy then the IRS is going to disallow it if they ever audit it. The market rate for something like that might be $50-100. So unless you have a business with 400 different toddler outfits to model - you're probably out of luck for them earning any income that could be put into a Roth IRA.


We have a small ecommerce business and hired our three oldest children (11-14) as employees and put them on payroll. They get paid minimum wage to work in our office/warehouse picking orders from the shelves, packaging products, labelling things, etc. Between the 3 of them they earned about $1,200 during the last few months of 2022 and I took half of it and put it into a Roth IRA for them.

[theolympians]

Yeah, I think one has to have income which could be placed in a retirement account. An infant can't work. The IRS might stretch things for a tween or teen, but an infant is another issue which I wouldn't touch.

I’m not sure why you said “might stretch things for a … teen” - A 14 year old can work 5 hours a day on non-school days and up to 25 hours per week, so long as the job is not classified as hazardous. At age 16 a child can work a full 8 hour shift, and there’s a variety of companies that will hire them.
What am I missing?

Not missing anything. My point was there is no way a 2 year old could be said to be earning income. The OP is considering sheltering money for them that wasn't earned by the 2 year old. You could do the same for a tween or teen. I was presuming the tween or teen were not earning income in that instance.

[uneven_cyclist]

Hey all, thanks so much for your replies, I really appreciate it. 

Alright, I think I'll probably hold off on this plan for now, pending further investigation. 

I'm a bit frustrated with the overall system because it seems as though if the accounts exist then the government must have some legitimate use cases in mind for infants, beyond just the single potential case of a parent who sells photos and then invests the money into a Roth on their child's behalf.

If there are no ways, or only one or two ways, for an infant to legally claim income without being either in violation of tax law or child labor law...then the whole system, at least for infants, seems a bit pointless.  It also makes me wonder -- if there are essentially zero ways in which this would be legit for an infant, then why does the IRS allow the accounts/contributions in the first place?  Granted, there would of course be exceptional cases where an infant earns over $6k from photos/modeling...but generally speaking it seems more like a pitfall than an opportunity to even offer the account.

Clearly that all changes as kids get older and kids can work in any number of different fields. 

In the meantime, I'll stay tuned for a Mad Fientist blog post about custodial Roth IRA accounts and will start learning all about 529 accounts. 

I'm considering now whether it is worth the hassle to ask a friend or relative to open a 529 on my son's behalf as a way of distancing him from that asset when the time comes to fill out the FAFSA...not even sure it would make too much difference in the grand scheme of things?  Open to any advice/input there as well.

Thanks again all for your time and input...lots of great info.

[nereo]

Hey all, thanks so much for your replies, I really appreciate it. 

Alright, I think I'll probably hold off on this plan for now, pending further investigation. 

I'm a bit frustrated with the overall system because it seems as though if the accounts exist then the government must have some legitimate use cases in mind for infants, beyond just the single potential case of a parent who sells photos and then invests the money into a Roth on their child's behalf.

If there are no ways, or only one or two ways, for an infant to legally claim income without being either in violation of tax law or child labor law...then the whole system, at least for infants, seems a bit pointless.  It also makes me wonder -- if there are essentially zero ways in which this would be legit for an infant, then why does the IRS allow the accounts/contributions in the first place?  Granted, there would of course be exceptional cases where an infant earns over $6k from photos/modeling...but generally speaking it seems more like a pitfall than an opportunity to even offer the account.

Clearly that all changes as kids get older and kids can work in any number of different fields. 

In the meantime, I'll stay tuned for a Mad Fientist blog post about custodial Roth IRA accounts and will start learning all about 529 accounts. 

I'm considering now whether it is worth the hassle to ask a friend or relative to open a 529 on my son's behalf as a way of distancing him from that asset when the time comes to fill out the FAFSA...not even sure it would make too much difference in the grand scheme of things?  Open to any advice/input there as well.

Thanks again all for your time and input...lots of great info.

Well, the IRS doesn’t “allow it” - that’s the whole thing. Our tax system is predicated on legally-binding self reporting, and a result is that one can do and claim all sorts of things which are most definitely not allowed, and can land you in legal peril if caught.

I’m less surprised by the IRS than I am that you can apparently open an IRA so easily at a brokerage for an infant. But there again, it’s all self reporting. The tax code does not (and I believe cannot) require brokerages to verify that you actually have earned income to contribute to your own IRA. You can even contribute $6500 on Jan 1, even with no income or job. Because it’s all self reporting and directed.

[Scandium]

I'm a bit frustrated with the overall system because it seems as though if the accounts exist then the government must have some legitimate use cases in mind for infants, beyond just the single potential case of a parent who sells photos and then invests the money into a Roth on their child's behalf.

If there are no ways, or only one or two ways, for an infant to legally claim income without being either in violation of tax law or child labor law...then the whole system, at least for infants, seems a bit pointless. 

I'm considering now whether it is worth the hassle to ask a friend or relative to open a 529 on my son's behalf as a way of distancing him from that asset when the time comes to fill out the FAFSA...not even sure it would make too much difference in the grand scheme of things?  Open to any advice/input there as well.

I don't think anyone, least of all the IRS, has claimed that there's a "point" to a wage-contribution based, tax-sheltered, retirement account to benefit infants. It's primary purpose is for people of working age to set aside a portion of their income. The fact that anyone of any age can open one I think is more a quirk than a intended benefit.

Apparently you can indeed set up a 529 account for non-family members. But I saw this warning:

since any money they receive to pay for college from anyone other than a parent will be counted as student income on the following year’s FAFSA. Student income can reduce a potential aid package by as much as 50% of its value.

https://www.savingforcollege.com/article/who-can-open-a-529-plan

[uneven_cyclist]

The fact that anyone of any age can open one I think is more a quirk than a intended benefit.

I think that is exactly right.  The source of my frustration is that I believe, as I I think most of us do, that that tax codes should function to drive progress in the societies in which they operate.

On an individual level, that means that they should drive individual citizens toward doing things that help both themselves and their community/nation etc. 

Setting aside resources to provide for the future education of an infant child is a perfect example.  Conversely, policies that contribute to to legal/cultural/moral red tape that disincentivizes citizens from setting aside resources in ways that would help themselves and the larger society = examples of ineffective tax code.  Custodial Roth IRA accounts for infants are actually an example of a good idea and a good system.  But if it's not actually legal, in 99% of cases, to actually use them (for infants), then that's not such a good idea, because then they essentially exist as a snare/trap hidden in the tax code.  Granted, most folks will never get trapped because audits are rare, but still...it seems like what's the point?

Thanks again all for sharing info on these accts...at least on a personal level I feel a bit more wary about using them for an infant.

Apparently you can indeed set up a 529 account for non-family members. But I saw this warning:

since any money they receive to pay for college from anyone other than a parent will be counted as student income on the following year’s FAFSA. Student income can reduce a potential aid package by as much as 50% of its value.

https://www.savingforcollege.com/article/who-can-open-a-529-plan

That's good to know about, thanks -- I'll look into this more before going any further down the 529 path.

[nereo]

since any money they receive to pay for college from anyone other than a parent will be counted as student income on the following year’s FAFSA. Student income can reduce a potential aid package by as much as 50% of its value.

https://www.savingforcollege.com/article/who-can-open-a-529-plan

That's good to know about, thanks -- I'll look into this more before going any further down the 529 path.
[/quote]


there's good reason to follow the Investment Order, which places 529s last alongside taxable accounts
https://forum.mrmoneymustache.com/investor-alley/investment-order/

You could of course invest that money in taxable and keep tabs of your basis for the time being, and then later use those funds to stuff a 529 if that is still appealing.

[Villanelle]

The fact that anyone of any age can open one I think is more a quirk than a intended benefit.

I think that is exactly right.  The source of my frustration is that I believe, as I I think most of us do, that that tax codes should function to drive progress in the societies in which they operate.

On an individual level, that means that they should drive individual citizens toward doing things that help both themselves and their community/nation etc. 

Setting aside resources to provide for the future education of an infant child is a perfect example.  Conversely, policies that contribute to to legal/cultural/moral red tape that disincentivizes citizens from setting aside resources in ways that would help themselves and the larger society = examples of ineffective tax code.  Custodial Roth IRA accounts for infants are actually an example of a good idea and a good system.  But if it's not actually legal, in 99% of cases, to actually use them (for infants), then that's not such a good idea, because then they essentially exist as a snare/trap hidden in the tax code.  Granted, most folks will never get trapped because audits are rare, but still...it seems like what's the point?

Thanks again all for sharing info on these accts...at least on a personal level I feel a bit more wary about using them for an infant.

Apparently you can indeed set up a 529 account for non-family members. But I saw this warning:

since any money they receive to pay for college from anyone other than a parent will be counted as student income on the following year’s FAFSA. Student income can reduce a potential aid package by as much as 50% of its value.

https://www.savingforcollege.com/article/who-can-open-a-529-plan

That's good to know about, thanks -- I'll look into this more before going any further down the 529 path.

But since there are cases, even if rare, where an infant has earned income, it makes perfect sense that the system is set up as it is. I'm not sure why that's frustrating or problematic. 

In addition to child models, does an inheritance count as earned income?  (A quick google search suggests it does.)  So that's another example.  But regardless, IRAs are to be funded with earned income, regardless of the age of the account holder.  I'm not sure why that's frustrating.

And brokerages aren't in the business of confirmed details about eligibility; that's up to the holder.  They also don't check to make sure someone falls under income limits, or doesn't have another IRA that would push them over the annual limit, or anything else. 

To me, all of this seems like the system functioning exactly as intended.  It would be problematic if they said that someone *couldn't* fund an IRA, based on age. 

It's not like an IRA is the only way to "drive progress" in the form of setting aside money for kids. 

[reeshau]

 
I'm considering now whether it is worth the hassle to ask a friend or relative to open a 529 on my son's behalf as a way of distancing him from that asset when the time comes to fill out the FAFSA...not even sure it would make too much difference in the grand scheme of things?  Open to any advice/input there as well.

Grandparents are getting special status, as of the 24/25 school year.

https://www.savingforcollege.com/grandparents

[AdrianC]

https://money.com/529-roth-ira-rollover/

“Save for College or Retirement? New 529 Rule Makes It Easier to Help Your Kid Do Both“

We had stopped 529 contributions, thinking that we probably had more than enough for each kid. We’re going to restart contributions now.

Never worried about FAFSA. Kid 1 is a sophomore in college and we didn’t bother filling out a FAFSA app.  It was very clear we wouldn’t qualify for anything based on other assets, never mind the 529. She got scholarships based on academics.

[mistymoney]

Yeah, I think one has to have income which could be placed in a retirement account. An infant can't work. The IRS might stretch things for a tween or teen, but an infant is another issue which I wouldn't touch.

I’m not sure why you said “might stretch things for a … teen” - A 14 year old can work 5 hours a day on non-school days and up to 25 hours per week, so long as the job is not classified as hazardous. At age 16 a child can work a full 8 hour shift, and there’s a variety of companies that will hire them.
What am I missing?

tween - 14 and 16 are teens ;)

tween years are ~ 8-12

[yachi]

https://money.com/529-roth-ira-rollover/

“Save for College or Retirement? New 529 Rule Makes It Easier to Help Your Kid Do Both“

We had stopped 529 contributions, thinking that we probably had more than enough for each kid. We’re going to restart contributions now.

Never worried about FAFSA. Kid 1 is a sophomore in college and we didn’t bother filling out a FAFSA app.  It was very clear we wouldn’t qualify for anything based on other assets, never mind the 529. She got scholarships based on academics.

For the sake of any other readers looking at your post, and imagining themselves in the same position, I want to share some numbers.

A few weeks ago I worked through the FAFSA formula to see what I need to set aside in our budget for my 7th grader's future college.  One of the things it reinforced is it's better for us to rent vacation cabins and houses than to own them, and I should plan on spending the money in my taxable brokerage account on yearly expenses or paying off my mortgage.

At first glance, it looks like parents would be expected to contribute 12% of assets toward college, but because there's a scaled contribution table, it's at most 5.64% of assets.  So the level of assets where assets alone put your EFC at 100% of the average cost of college ($35,551) is $630,000 if you have one child in college, and $1,260,000 if you have two.  Keep in mind also that your primary house, IRA, 401(k), and most personal assets are exempt from the asset calculation.  Also small business ownership is treated differently.  What's left is vacation and rental houses, savings accounts, and taxable brokerage accounts.

I have no doubt there are mustachians with these levels of assets, but there are also mustachians with the majority of their assets in retirement accounts.  The second category can receive substantial financial aid, especially if they keep their spending and income low.

[uneven_cyclist]

https://money.com/529-roth-ira-rollover/

“Save for College or Retirement? New 529 Rule Makes It Easier to Help Your Kid Do Both“

We had stopped 529 contributions, thinking that we probably had more than enough for each kid. We’re going to restart contributions now.

Never worried about FAFSA. Kid 1 is a sophomore in college and we didn’t bother filling out a FAFSA app.  It was very clear we wouldn’t qualify for anything based on other assets, never mind the 529. She got scholarships based on academics.

For the sake of any other readers looking at your post, and imagining themselves in the same position, I want to share some numbers.

A few weeks ago I worked through the FAFSA formula to see what I need to set aside in our budget for my 7th grader's future college.  One of the things it reinforced is it's better for us to rent vacation cabins and houses than to own them, and I should plan on spending the money in my taxable brokerage account on yearly expenses or paying off my mortgage.

At first glance, it looks like parents would be expected to contribute 12% of assets toward college, but because there's a scaled contribution table, it's at most 5.64% of assets.  So the level of assets where assets alone put your EFC at 100% of the average cost of college ($35,551) is $630,000 if you have one child in college, and $1,260,000 if you have two.  Keep in mind also that your primary house, IRA, 401(k), and most personal assets are exempt from the asset calculation.  Also small business ownership is treated differently.  What's left is vacation and rental houses, savings accounts, and taxable brokerage accounts.

I have no doubt there are mustachians with these levels of assets, but there are also mustachians with the majority of their assets in retirement accounts.  The second category can receive substantial financial aid, especially if they keep their spending and income low.

Thanks for this info both of you and also @reeshau for the clarification about grandparents being the relatives who would be exempt based on new legislation.

I went to studentaid.gov and to savingforcollege.com to try a couple of calculators as well and something that also struck me was that it seemed as though the upper ceiling on Federal Pell grants was not, actually, *that high* ($6000-$7000-year max if I was reading correctly)...at least that high relative to the annual tuition of most state colleges.  I know that some states have very generous state grants as well, but something worth knowing as well.

And based on @yachi 's post, then it seems like the biggest liabilities in terms of qualifying/getting a low Expected Family Contribution/EFC might just be the size of your brokerage acct and maybe also the size of the 529 as well.  As others have mentioned, you could maybe navigate around this by having a grandparent manage the 529...  But I'm not so thrilled about that possibility.  My son won't actually be starting school for another 16 years, and his grandparents are already in their 70s...so that is definitely a consideration.  Also I am am not eager to dive into managing a 529 with my parents or parents-in-law for what might be a lost cause anyway if my taxable account balance were to climb high enough that my son no longer qualified for grants anyway.   

So...even though I was really hoping someone out there would show me a way that the Roth IRA made sense, I think that I'll probably end up funding a 529.  It will still provide tax-free growth and then insulate my wife and me from the necessity of taking larger (and taxable) withdrawals from our own accts down the line.

If it turns out that our son doesn't use all of the 529 money then we'll look into what @AdrianC was mentioning in terms of rolling over some of the fund into a Roth after he's an adult etc.

Thanks all for your replies and info.

[AdrianC]

At first glance, it looks like parents would be expected to contribute 12% of assets toward college, but because there's a scaled contribution table, it's at most 5.64% of assets.  So the level of assets where assets alone put your EFC at 100% of the average cost of college ($35,551) is $630,000 if you have one child in college, and $1,260,000 if you have two.  Keep in mind also that your primary house, IRA, 401(k), and most personal assets are exempt from the asset calculation.  Also small business ownership is treated differently.  What's left is vacation and rental houses, savings accounts, and taxable brokerage accounts.

Yes, there's that, plus if the kid has assets they count also. IIRC the FAFSA counts 20% of a kid's brokerage account or cash.

[Heroes821]

Late to this conversation, but I know several people who pay their children the right amount of income for their IRAs to use their likeness on social media, i.e. post their kids pictures on facebook.  Not sure how likely that is to cause an audit but its more than 1 person I know who does it and has done it for years now without issue.

[EvenSteven]

Late to this conversation, but I know several people who pay their children the right amount of income for their IRAs to use their likeness on social media, i.e. post their kids pictures on facebook.  Not sure how likely that is to cause an audit but its more than 1 person I know who does it and has done it for years now without issue.

This sounds like tax fraud. The question then becomes, "If I have a high likelihood of getting away with tax fraud, should I do it?"

[ixtap]

Late to this conversation, but I know several people who pay their children the right amount of income for their IRAs to use their likeness on social media, i.e. post their kids pictures on facebook.  Not sure how likely that is to cause an audit but its more than 1 person I know who does it and has done it for years now without issue.

Do they monetize their social media? If not, I don't see how this could be remotely legit.

[Michael in ABQ]

Late to this conversation, but I know several people who pay their children the right amount of income for their IRAs to use their likeness on social media, i.e. post their kids pictures on facebook.  Not sure how likely that is to cause an audit but its more than 1 person I know who does it and has done it for years now without issue.

This sounds like tax fraud. The question then becomes, "If I have a high likelihood of getting away with tax fraud, should I do it?"

Definitely sounds like tax fraud and they just haven't been caught yet. Understandable since going after Roth IRAs that weren't really funded with earned income is probably pretty low on the priority list for audits. It's a lot easier to target things like two parents each claiming the same child on individual returns for a child tax credit or earned income tax credit. It's pretty simple to see if a social security number shows up on more than one return.

[nereo]

Late to this conversation, but I know several people who pay their children the right amount of income for their IRAs to use their likeness on social media, i.e. post their kids pictures on facebook.  Not sure how likely that is to cause an audit but its more than 1 person I know who does it and has done it for years now without issue.

This sounds like tax fraud. The question then becomes, "If I have a high likelihood of getting away with tax fraud, should I do it?"

Definitely sounds like tax fraud and they just haven't been caught yet. Understandable since going after Roth IRAs that weren't really funded with earned income is probably pretty low on the priority list for audits. It's a lot easier to target things like two parents each claiming the same child on individual returns for a child tax credit or earned income tax credit. It's pretty simple to see if a social security number shows up on more than one return.

If deemed fraudulent, could the kids IRA be subject to penalty years or even decades later?

[oneday]

If deemed fraudulent, could the kids IRA be subject to penalty years or even decades later?

My understanding is if fraud is found, then the IRS can go back an unlimited number of years to look for more. Not just the 7 years that they normally tell people to keep records of.

Something like this, I bet they go back as far as returns exist. Once detected in one year, it would be easy to find in older years.