Earlier this year, when I sat with my accountant to talk taxes, the subject turned to my son. He will be 12 soon, and I wondered about hiring him to do work for my home business. I wanted to pay him, and then have him put some of his earnings in an investment account to grow over time.
My accountant said that it was a good idea. But, of course, my son is a minor. He can’t just open an investment account. I need to open it for him. So that’s what I did. I opened a custodial Roth IRA for my son so that he can invest half of his earnings from doing administration-type tasks for my home business.
Custodial investment account
It’s important to understand that a custodial investment account is one in which you manage the money on behalf of your child. However, the money is your child’s. Once the money goes into that account, it belongs to your child. As soon as your child reaches the age of majority specified by the applicable state law, he or she has control of that money. This is contrast to a guardian account, in which you open an account on behalf of your child, but you still own the money.
One of the nice things about a custodial investment account, though, is that dividends and other income from the account are taxed at the (usually) lower child tax rate. In my son’s case, that is irrelevant, since his account is a custodial Roth IRA. The nice thing about the Roth IRA is that the money grows tax-free, since contributions are made with after-tax dollars. Since my son won’t actually earn enough money to be taxed on his earnings, he essentially gets a totally tax-free investment account. It’s also possible to open an Education IRA, and contribute on behalf of your child.
You can also open up a taxable custodial investment account for your child. You can make trades on behalf of the child, and even earn income from the account. However, the understanding is that you will use income from investments in a custodial investment account for the benefit of your child. There have been cases in which parents have used these accounts for tax benefits, and taken the earnings — and later the children have sued.
Remember that you are the custodian of your child’s money in these cases. It’s up to you to make the best possible decisions for the benefit of your child. That way, when he or she grows up and takes control of the money, there is plenty of it to work with.