Although taxpayers rarely think about tax savings opportunities for their low-income children, setting up an individual retirement account for a child may provide an excellent, inexpensive opportunity for long-term financial planning.
The following example illustrates how this strategy might work:
Once your child starts working -- at a part-time job or even as an occasional baby-sitter -- you can begin investing the child's yearly earnings, up to $2,000 a year tax-deferred, in an IRA. However, the child must have salary or other compensation to contribute to an IRA.
Investment income such as dividends, interest, rents or capital gains do not qualify for IRA protection. To compensate for the $2,000 (or less) of income the child is losing, the parents can make annual gifts to the child.
The child will be required to file a tax return showing the earnings. However, with the use of a $2,000 IRA, a child may shelter up to $5,600 of income from federal taxes.
For example: Stacy Lynn, a 15-year-old dependent child, earns $5,600 a year from her part-time job. Stacy puts $2,000 into an IRA and receives a compensating, tax-free $2,000 gift from her father.
Gross income $5,600.
Less IRA deduction $2,000.
Adjusted gross income 3,600.
Less standard deduction 3,600.
Taxable income 0.
Note: Since Stacy is claimed as a dependent on her parents' tax return, she cannot claim a personal exemption deduction.
Here is what makes this $2,000 IRA program worthwhile: If Stacy or her parents make a contribution of $2,000 a year for 10 years -- until she is 25 -- then by the time she reaches age 65, the account will have grown to more than $650,000, assuming an 8 percent rate of return on the invested funds.
By comparison, if Stacy is more like the typical taxpayer and doesn't start thinking about an IRA until age 35, a similar 10-year contribution program would accumulate only $150,000 by age 65.
There are some drawbacks to this IRA program. For one, the IRA money cannot be used for college tuition or for a down payment on the child's first home without a federal tax penalty of 10 percent under present law. Essentially, IRAs should be regarded as long-term investments, an integral part of an individual's retirement portfolio.
Social Security taxes (FICA) on employees and employers are percent on earnings up to $55,000. For self-employed taxpayers, the 1992 rate is 15.3 percent, up to the same $55,500 earnings maximum.
The Medicare portion of Social Security taxes continues beyond these earnings limits. For employees and employers, an extra tax of 1.45 percent is imposed on earnings between $55,501 and $130,200. For self-employed taxpayers, an extra Medicare tax of 2.9 percent is imposed on the same earnings range.
Taxpayers 65 to 69 can earn as much as $10,200 per year without losing Social Security benefits. For every $3 over that limit, $1 of benefits is withheld. For taxpayers under age 65, the earned income limit is $7,440. For every $2 over that limit, $1 of benefits is withheld. For taxpayers age 70 or older, there is no limit on how much can be earned.