By Devin Watts
If you’re a 1099 physician or practice owner and have one or more children, then you have a unique opportunity to use a minor Roth IRA to pay for college expenses, as well as save for their future retirement. This strategy will require that you employ your child(ren) within either your 1099 business or your practice. The logistics can be particularly difficult to figure out, as there are many things to consider and a lot of nuances. To help you with this process, I’ve outlined the 5 steps you need to follow to take advantage of this great savings opportunity.
*Important Note: You can withdraw your Roth IRA contributions at any time, tax and penalty free, for college expenses. However, any earnings withdrawn before age 59.5 for college expenses will be taxed, even though it still qualifies to avoid the penalty. When making a withdrawal, your contributions are always considered the portion that is withdrawn first.
With that said, let’s jump into the 5-steps for optimizing your child’s Roth IRA for college savings and their retirement.
Step 1 – Employ your child
Your child will need to be considered a bona-fide employee and be paid a reasonable wage for the work that’s performed. It’s suggested as a best practice to document their employment just as you would for any other employee. These records will be helpful in case anything ever comes into question with the IRS.
It’s recommended that you have a bank account set up in your child’s name so that their earnings can be direct deposited, furthering the paper trail.
For these reasons, we highly recommend you consult your accountant when paying your child as an employee or when you are adding your child to the business payroll. Ideally you would target paying them at least the amount of the Roth IRA contribution limit ($7,000 in 2024). But the wage must be considered reasonable for the duties performed. This article talks more on age and wage appropriateness.
Your child’s earned income now allows you to make contributions to their Roth IRA.
Step 2 – Open Roth IRA for your child
When opening a Roth IRA, technically a minor cannot do it on their own, so the account must be opened by you, the parent or guardian. The minor’s Roth IRA will remain under your management until the child reaches the age of majority, which differs in each state, but is typically age 18. Most financial institutions call this type of account a “Minor Roth IRA”. Some banks may refer to them a little differently. For example, Fidelity refers to these accounts as “Roth IRA for Kids”.
Once your child reaches the age of majority, they can open a Roth IRA in their own name and obtain ownership of the Roth savings. You will then need to call the investment company to have the assets transferred into your child’s own Roth IRA.
*Important Note: Make sure the Roth IRA was opened at least 5 years before college. If not, any investment gains in the Roth IRA could be subject to the 10% penalty.
Step 3 – Contribute to the Roth Yearly
Make sure to do this before the April tax-filing deadline. The annual contribution is limited to 100% of your child’s earned income during the year and the annual contribution limit set by the IRS ($7,000 in 2024), whichever is lower.
Example 1: Cody earns $3,000 in 2024 working for his parents’ practice. The parents can contribute $3,000 into Cody’s Roth IRA for that tax year.
Example 2: Cody earns $10,000 in 2024 working for his parent’s practice. The parents can only contribute the max $7,000 into Cody’s Roth IRA.
Because contributions to the Roth IRA are limited, you should try to max the contributions as often as possible to take advantage of this great way to save for their future.
Step 4 – Invest your child’s Roth IRA
As you’ll see in the example of Zoe’s Roth IRA in Step 5, compounding growth with investments over 50 years has a huge impact!
Investing your child’s Roth IRA for college expenses requires careful consideration. Because the goal to save for kid’s college can be a near term goal, consideration on risk tolerance and investment strategy should be reviewed each year. However, since the earnings are best left in the account to grow for their future retirement, creating an investment strategy can be a difficult task. We recommend reviewing the strategy with a professional, and especially as your child progresses through high school.
Some mistakes that can be made with investing your child’s Roth IRA for college expenses:
Being too aggressive and not having a backup plan if investment values decline when college expenses are in the near term.
Being too conservative with investments while the child is young may limit the growth potential to be maximized.
Getting an advisor’s expertise on investing your child’s Roth IRA can help you avoid these common mistakes.
Step 5 – use contributions for college
When utilizing a Roth IRA for college, make sure you’re considering possible taxes, penalties, and the impact on financial aid eligibility. If the Roth IRA has been opened for five years or more, there are no penalties on withdrawals taken for college expenses. However, we think the earnings are best left for their future retirement (after age 59 1/2), since it will avoid income tax.
Remember, any withdrawals for college must take place in the same year as the actual expenses. Otherwise, taxes and a 10% penalty will be imposed on the investment gains.
The amount you’ve contributed over the years is then able to be withdrawn tax-free!
Saving into your kid’s Roth IRA is an extremely beneficial strategy when just the principal portion (amount contributed) is earmarked for college expenses. By starting contributions early and staying consistent with maximizing the contributions each year, you benefit from having more principal savings. You also set your kid up for more compounding growth opportunities. To further maximize the Roth IRA strategy for your child, we recommend that, if possible, any investment earnings be earmarked for your child’s future retirement.
To breakdown this down, here’s an example of how to maximize your child’s Roth IRA savings strategy:
Brandon operates as an independent contractor and has his 8-year old daughter Zoe helping in his business. Zoe earns $7,000 in 2024 and therefore Brandon is able to max Zoe’s Roth IRA contribution. Brandon & Zoe are able to maintain this $7,000 annual contribution over the next 10 years, amassing $70,000 of Roth IRA contributions (principal).
Brandon also saved into a 529 plan for Zoe’s college after she was born and is able to fund three of the four years of Zoe’s undergrad studies via the 529. The last year of Zoe’s studies costs $32,000 and Zoe is able to cover her expenses using her Roth IRA and pay $0 in taxes and $0 in penalties because the distribution is a removal of contributions. The best part is over the 10 years of contributions to Zoe’s Roth IRA, and 14 years of investment earnings, she has amassed a Roth IRA balance of $105,9602 and continues to receive tax-free growth (assuming 8% annual rate of return). This is even after Zoe’s last year of college is paid for!
So not only has college been fully funded, but Brandon just turbo charged Zoe’s retirement savings. If we chart out the compounding growth of Zoe’s hypothetical Roth IRA balance after college of $105,960, and the same annual rate of return of 8%, Zoe’s Roth IRA is projected to grow to $1,973,5343 by the time Zoe is 60! That doesn’t even factor in Zoe saving on her own after college. That’s amazing!
Using a Roth IRA for college expenses is a fantastic planning opportunity for physician business owners. We have helped many physician families start saving for their kids’ future including the use of a Minor Roth IRA. If you are interested in learning more or scheduling a complimentary consultation to receive clarification on your situation, please click “Work with Us” at the top.
Other helpful resources: How 529 savings account withdrawals are taxed differently than a Roth IRA.
1 - Investment returns are not guaranteed. Investing in securities involves risks, including the potential for loss of principal. Estimate is for illustration purposes only, is based on annualized returns of 8%, and is not intended to be representative of any specific investment or strategy.
2 - Roth IRA growth assumption & calculation: Growth on contributions - n:10, i:8%, pv:0, pmt: -$7,000, fv: $101,405 (fv = the estimated Roth IRA balance after 10 years of contributions)
Age 22 balance after $32k withdrawn (no contributions during college) – n:4, i:8%, pv: -$101,405, pmt: 0, fv: $137,960 (minus $32,000) = $105,960.
3 - Growth of Roth IRA balance for Zoe after college: n: (age 60 - age 22) 38, i: 8%, pv: -$105,960, pmt: 0, fv = $1,973,534
