Why fund a child's Roth IRA?

In my previous post I talked about how to save on your taxes by paying your children. I also encouraged parents to use at least some of those wages on funding a Roth IRA. A couple of people have since asked why a Roth IRA instead of a regular IRA or just normal brokerage accounts?

A Roth IRA offers significant advantages over either of the other two investment types and could be a great tool for teaching your children.

Compounding what?

As many individuals, wiser than I, have noted, a young person's best asset is time. By the miracle of compounding interest, the earlier a person saves the greater the benefit. Just about everyone has heard the tale of how Jon started saving $1,000 a year at age 20 while George started saving $2,000 a year at age 30. When they each turned 50, Jon had considerably more money than George.

Unless you are in the business of start-ups (where fortunes are created and lost in a matter of days), nothing helps money more than time. If I could magically speed up the clock and jump 30 years forward I would find that not only are my houses all paid off, but they are worth over 3 times as much as they were (assuming a conservative 4% appreciation each year).

So help give your children a head start on saving for their future life, and help them learn to start saving money now.

Why into retirement?

So if we're going to help our children save, why not put that money into a more typical brokerage account? Why put it into a retirement account?

I've never been impressed more than with Warren Buffett's decisions to leave the vast majority of his wealth to charity. Buffett refers to the children of wealthy people as "the lucky sperm club" and repeatedly insists that to pass along great wealth to your children can often hinder them, instead of help them. The author of The Millionaire Next Door agrees, and makes a strong case in his book that giving too much money to a child will make them more dependant on you, not less.

A popular trend that is emerging these days is to pass on your wealth to your children, but to limit their access of it until certain periods of their life. A certain amount might be accessible immediately, a little more might be given to them when they hit 30 or 40. Usually the entirety of the amount is passed along when the child reaches 50 years old.

The theory behind this method of disbursement is that by delaying the balance of money until the child reaches 50, they will have to work hard throughout their lives and earn their own money. They only receive the exceptional gift at a point in their lives when they are set in their ways and unlikely to make any significant changes to their lifestyles.

The same philosophies are true with any gift of money. Any unexpected money is likely to make your child more reliant on the source of that money than less. Let's look at an example where you put $3500 of your child's yearly wages into a stock index fund, between the ages of 10 and 18. The fund returns an annualized average of 10%. By the time your child heads off to college he'll have over $47,500 stashed away in those accounts.

Think back to your post-high school years. What would you have done with $47,000? Would you have made a down payment on a nice home? Or would you have bought a bitching BMW Z6 convertible? Maybe you would have let it sit. But more likely you would have spent every spring and summer in Cancun.

The advantage of an IRA is that the government tries hard to discourage people from taking money out until they are 60. It helps even more if your child doesn't have direct access to the broker in charge of the account. By putting the money in the hands of a retirement account, you've helped limit the allure that the cash holds over all of us who have windfalls.

Retirement account have other added benefits as well. When your child decides to purchase their first home, they can withdraw up to $10,000 out of their retirement plan without penalty. If something happens and some medical bills pile up, those can also be paid for out of their retirement plan without penalty. By building a retirement account for your children, you have given them a safe cushion to protect them from disasters, but kept them from wasting it away themselves.

Pay taxes and die

There's an old saying that says there are only two certainties in life, death and taxes. The first may be completely unavoidable, but the second can be dodged from time to time with careful maneuvering.

A traditional IRA is a retirement vehicle that allows you to reduce your taxable income today at the expense of future taxes. For example, if you earned $100,000 this year, but put $10,000 of it into a traditional IRA, then your taxable income would be $90,000, saving you roughly $3,000 in taxes. However, when you withdraw that $10,000 later in life you'll have to pay taxes on it. The IRS eventually does get their hands on that money, they just have to wait for it.

Out children, however, don't have to deal with paying much (if anything) in the way of income taxes. If their income was under the standard deduction, then they will pay nothing in income tax. So they should be looking at using a Roth IRA instead. A Roth IRA taxes you on your income now, but the benefit is that when you take the money out later you pay no taxes at all. That $47,000 we helped our children raise in the previous example will be 100% tax free when they retire. And since they didn't have to pay any taxes on it when they put the money in, the result is a retirement fund that the IRS will never touch.

For further reading on IRAs and Roth IRAs, take a look at the IRS's official pamphlet on the subject. It's a bit dry reading, but at least it's not written in legalese.

The littlest millionaire

There are plenty of advantages that real estate investing provides over other forms (including stocks). One of them is the sheer simplicity of making your children millionaires, and at a discount to you. The key to this simple trick is employment. Employ your children and pay them wages. Take those wages (which they probably won't have to pay taxes on) and put them in a Roth IRA for them.

First I need to make a quick legal disclosure. I'm not actually a lawyer, though I'm sometimes mistaken as one. The basis of the child labor discussion in this article is the federal Fair Labor Standards Act (FLSA), but every state has their own additional labor laws. While I feel confident that my recommended course of action shouldn't violate any laws, you should further research the child labor laws in your own state.

However, with that boilerplate out of the way I should tell you that child labor laws are generally designed to prevent people from exploiting children and protecting them from dangerous work environments. Since our purpose isn't to exploit our child's labor, but rather to expose them to the world of business and investing (as well as give them a financial head start), we're probably safe from that first condition. And the most dangerous thing our child may experience in our line of work is a rabid mortgage broker, so we're probably covered with the second as well.


What if your child's iPod was tax deductible?

There are obvious life lessons that can be taught through paying your children a wage. Younger children can learn the money results from doing work, not begging their parents. Other lessons, such as saving and budgeting, can be very easily incorporated. However I'm not a psychiatrist, nor am I Dr. Phil, so I'm going to refrain as much as possible from telling you how to parent. Instead I want to focus on how paying your children affects you.

When you pay your child (or any other employee of your business) those wages are deducted from your income in the same way as any other expense. If your company made $100,000 last year and you spent $10,000 on advertising and $10,000 in paying your children, the IRS will only tax $80,000. OF course the IRS doesn't just forget about the $10,000 you paid your children, that money is now their (taxable) income.

However, generally, children are taxed the same way as everyone else, and they are entitled to the same deductions as everyone else. This year the standard deduction for a single tax-payer is $5,000. So if your child earned $5,000 from you this year that money is entirely income tax-free. If you are in the 28% tax-bracket, you have just saved your family $1400 in taxes. No matter how that money is spent (on clothes, to fund a Roth IRA or on an iPod), you've avoided the taxes.

How do I deal with my child's income, and what about taxes?

The IRs tells us that a minor only has to file a return if they earn over $5,000. This actually get slightly more complicated to figure out if your children have unearned income as well (like stocks), but odds are that you won't even have to file paperwork with the IRS unless you need to get a tax refund.

But the refund is a moot point since, if your child is earning that little, you don't have to withhold any money for the government (though you will have to report the earning, which is discussed later).

So we don't have to give the government any money for the child's income taxes, but what about Social Security? If you run your business as a sole proprietorship, general partnership, or an LLC that is taxed like one of those two entities, niether you nor your child will be responsible for paying any social security taxes. If instead you chose to form a corporation, or an LLC that is taxed like a corporation, you unfortunately will be responsible for paying Social Security.

Yet another reason why I don't recommend incorporating yourself.

So how can I put my child to work and what should I pay them?

Generally children under the age of 14 are not allowed to work. However the federal law exempts the age restriction on parents who are employing their children (section 29 CFR 570.2 - Minimum age standards). So the federal law places no restriction on the age at which your child can begin to work.

It's worth noting, however that the age exemption only applies to parent's or "those playing the role of a parent". It appears that the court interprets "playing the role of a parent" as raising and providing for the child, so unless you are directly raising your nephew/grandchild/cousin, you are not allowed to hire them at younger than 14. In addition you cannot hire your grown child, who then hires their minor child. The parents must own the business in order to exercise this exemption. Of course, once the child reaches the age of 14, they can be hired by anyone regardless of relation.

Pay is something that is left to the employer, all that's mentioned in the laws is that they are to be paid a fair wage. Paying too high will probably be more of a problem for us than paying too low.

It's highly unlikely that the FBI will be knocking down our doors for violation of child labors laws, so it seems that our chief concern lies with the IRS. Part of your reasoning for hiring your child is the tax benefits, and the IRS's job is to get you to pay every last cent that they legally can. Hiring your children, though completely legal, is likely to run up a red flag at the IRS and they'll probably keep a somewhat closer eye on you. To protect yourself in the event of an audit, you'll need to follow a few steps.

1. Request an Employer Identification Number (EIN). This is required before you can hire anyone, and it's a free simple process created by the IRS.
2. Assign jobs that are acceptable for your child's age. An 6 year old could help you fold letters or lick stamps. A 10 year old could help you rake leaves on a rental property. A 14 year old could help you paint.
   
3. Only pay them for jobs that are directly related to your business. Mowing the lawn of a rental property applies. Mowing your lawn doesn't (you can still pay them for mowing your lawn, you just can't deduct it from your business).
   
4. Keep a detailed record of all of your children's hours and efforts. Use a notebook or a spreadsheet, but carefully record dates, hours worked and work accomplished. Don't record that your 6 year helped you fix the plumbing, instead record that he/she held the light for you to see what you were fixing.
   
5. Pay a fair wage. Don't pay your children $50 an hour to lick stamps.
   
6. Issue a W-2 at the end of the year for your children. Each child should get their own.
7. File a 944 form with the IRS every year. The 944 Form is your way, as an employer, of notifying the IRS of the wages you paid out. Without this form, they'll view your deductions as very suspect (and probably illegal). By the way, the 944 form is a new, annual version of the old 941 form that had to be submitted quarterly. You can only use 944 if your employees' tax liability (the amount they are expected to pay in taxes) is less than $2500.
   

So there we have it. In one not-so-simple step we've managed to teach our children about our business, instruct them in the value of the dollar, build a solid financial foundation for their future, and save ourselves taxes to boot. Running a real estate business can be a lot of work, but the pay offs can be grand.

And if you get your children to work for you from age 10 until age 18, putting $3,500 away each year into a Roth IRA, earning 10% a year, they could go to college with nearly $50,000 tucked away, TAX FREE. If they never save another dime (just the original $28,000 you put away for them) they'll be millionaires before they are 50.

What is depreciation?

If you are interested in real estate investing you've probably heard about depreciation and how it can work wonders on your tax returns. Every Top 10 list of benefits for landlords includes depreciation. A lot of people will even tell you how to calculate it into your taxes. But what is it really? Let's start from the beginning.

When you run a business you only pay taxes on your profits. If you collected $100 by selling bananas, but buying the bananas cost you $25, you are only taxed on $75, not the full $100 (Profit = Revenue - Expenses). This is simple and it makes perfect sense (this is true whether you have formed a corporation or not). But it can get more complicated really quick.

Let's say your banana business is booming and you need to buy a bike (to deliver the bananas to seniors, an expanding market), and the bike costs you $100. So this year you are spending $125 and making $100, therefore you wouldn't pay taxes, right? Or maybe you financed the bike and only have to pay $20 this year. How would that affect your taxes?

The government steps in at this point and say "we need a simple way to figure out how long-term purchases affect taxes" (And believe me, this is a good thing. Otherwise accountants would be running around all willy-nilly and figuring out ways for businesses to never pay taxes, increasing the burden on you and I). So the government looks at your bike and says, "We think that bike will last 4 years before you need a new one. So each year you can count one fourth (25%) of the cost of your bike as an expense."

So now the government is basically saying "We want you to pay taxes every single year. But we have to admit that the bike is an expense and should reduce your taxes. So since we think you will have to buy a new bike every 4 years, we'll spread the expense of that bike over 4 years." So now, for the next 4 years, our expenses are $25 for the bananas and $25 for the bike giving us a deduction of $50 on our tax return. If we paid cash for the bike that means that in year two we're making $75 profit but only paying taxes on $50.

This rule goes for every thing a company uses, that lasts many years but eventually breaks down and has to be replaced. FedEx can depreciate their fleets of delivery trucks, Ford can depreciate the machines in their auto plants. And since the government can't look at every piece of equipment they've created nifty little tables that help companies figure out how much they can depreciate for their new truck or bike.

Now when you bought your investment house, the government says you actually bought two things. It says you bought a piece of land, and you also bought a building on top of it. This is important to them because while land doesn't wear out, a building does. The house you bought is wearing out and every last part of it will eventually need replacing (like your roof).

So the government says that because we are using the house to make money and because the house is wearing out, we should be able to depreciate it (use part of the cost of the house as an expense). The government tells us that they expect an average house to last 27.5 years and they've given us a little table to use in figuring out how much we can deduct each year.

So how does this impact our personal taxes? Pretend Tommy Hillbilly earned $10,000 last year in taxes. Over the year he paid $9,000 in mortgage interest, and also paid about $1,000 in regular expenses (advertising his house, buying paint, etc). On his income tax return he claims revenue of $10,000 and expenses of $10,000, giving him a taxable profit of $0. That's nice, since he won't owe an extra taxes.

But Tommy was smart and deprecated his house. According to the tables above he gets to deduct $5,000 in wear and tear on the house. So now he has revenue of $10,000 and expense of $15,000. So he'll probably be looking at a nice tax return this year. The amount he gets back depends on his tax bracket, but it's money in his pocket right now.

There's only one final catch to depreciation. When you depreciate an asset, the government is expecting the value of that asset to drop to $0 (like a broken down truck). So if when you sell your home (and it's worth something) the government wants to be paid back for the tax breaks it gave you. While the gains on a long term house sale are a measly 15%, the depreciation you claimed is taxed at a much larger 25%. This is called recapturing depreciation.

In other words, say you buy a house for $100,000 and the house is valued at $75,000 (the remaining $25,000 is the value of the land). You claim the full 3.6% depreciation each year and then sell 10 years later for $250,000. Over the 10 years you claimed $2,700 as a deduction each year (in depreciation) for a total of $27,000. So when you sell your taxes will be 25% of $27,000 (recapturing your depreciation) and 15% of $150,000 (capital gains tax for your profit). You'll pay $6750 in depreciation recapturing.

Or, in a simple form, when you sell you owe the government:
$27,000 (the amount you depreciated)
x 25% (the depreciation tax rate)
= $6750 is the amount you have to pay the government in recapturing depreciation

$250,000 (the amount you sold the house for)
- $100,000 (the amount you paid for the house)
= $150,000 (the capital gain you got for the house)
x 15% (the capital gain tax rate)
= $22,500 is the amount of tax you have to pay for your gains

Your total tax bill will be $6750 + $22,500 = $29,250. (It's important to note here that in this situation, the capital gains tax would remain the same whether or not you had depreciated the property)

So is there an advantage in depreciation? If you tax rate is 25% or higher that answer is obviously yes. But what if you happen to have a lower tax rate, say 20%? Well, each of the 10 years you save $540 in taxes from depreciation. If you put that money in a decent savings account and earn 5% on it, then after 10 years that account will be worth $6792. When you have to pay your depreciation recapture tax bill of $6750, you'll be left with $42. Obviously not much of a gain, but it's still a gain.

(For the record, if your tax rate is 33% your account will end up worth $11,206, therefore depreciation will save you almost $5,000). In addition to the extra cash, you will have access to that money throughout the 10 years in case of any emergencies (like the aforementioned roof), which could help you avoid having to take out a loan.

So, in short, depreciation is simply the government's way of letting you deduct the expense of buying a house, but over a long period of time. Any questions?