How to Make Your Kid a Tax-Free Millionaire

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Year-end is a good time to think about your taxes, especially in a year that saw the biggest changes (like them or not) to our federal tax code in more than a generation. The famous (and often misattributed) quote goes, “‘Tis impossible to be sure of any thing but death and taxes.” (Christopher Bullock, 1716). More than 200 years later, medical researchers keep trying to disprove the certainty of the former, while Washington DC keeps proving that of the latter. A while back, I found a loophole that lets you legally help your teenager become a millionaire without his or her paying a dime of income tax, for less than $20,000! This loophole seems to be unaffected by the new tax law, and in the following I show exactly how to take advantage of it.

My wife and I have three kids, and like most parents we do everything we can to help them be successful, including putting them through college. While the total cost of attendance of a four-year college can range from $100,000 to over $250,000, the Social Security Administration says that, on average, a college degree increases lifetime earning by $630,000 to $900,000 while a graduate degree could be worth between $1,100,000 and $1,500,000.

Our two older kids both graduated from college, and our youngest is there now, so it’s clear we see this as a worthwhile investment. However, I always try to find a better solution, a “hack” if you will, to help our kids even more, and a while back I came up with exactly that and we’re using it to help our youngest.

Here’s what you need:

  • A teenager willing to work enough while in school to earn more than $5500 a year
  • A business willing to hire her (it’s simpler if it’s your practice, but that’s not crucial)
  • An agreement with your teen that she will invest $5500 of her earnings each year rather than spending it, in return for you gifting her $0.50 that she can spend for each $1 she invests
  • Enough money to cover your end of that deal for seven years ($2750 per year)

How does it work?

It’s based on something Congress established as part of the Taxpayer Relief Act of 1997, the Roth IRA – a form of individual retirement arrangement where a person contributes after-tax money, but then doesn’t have to pay any tax when they withdraw money in retirement. You can read more details about the Roth IRA here, but the crucial part is that there has to be income from work. “Wait a minute,” you might be thinking, “you said this could be done without paying taxes and now you’re telling me contributions have to be after tax!” That’s why I said you need a teenager, because she doesn’t earn enough to owe income tax, and has a very long time until retirement.

Here’s what you and your teen do:

  • From age 16 until graduating from college at age 22, she works enough to earn at least $5500 a year, perhaps running your practice’s social network marketing or writing blog posts
  • You open a Roth IRA for her (for example, with a low-cost S&P 500 index fund or target-date retirement mutual fund)
  • Each time she gets paid, you help her invest all of it (making sure the total for the year doesn’t go over the Roth IRA contribution limit, currently $5500)
  • Since most kids aren’t big on decades-long delay of gratification (ours certainly isn't :)), you give her $0.50 to spend now for each $1 she invests for retirement
  • If needed, you (perhaps with the help of your CPA) help her file tax returns that most likely will show $0 income tax owed
  • She agrees to leave the Roth IRA alone until she retires at age 67 or later

That’s it! Over this seven-year “program,” your daughter invests $5500 each year in return for you gifting her $2750 each year. Your total cost is $19,250. Her total contribution is $38,500. Assuming an average annual return a tiny smidge over 7% (stocks have returned about 10% a year on average since before the Great Depression), when she reaches age 67, she should have just over a million dollars in that Roth IRA account (see table below), and since it’s a Roth, she’ll never have to pay income tax on any of it.

In fairness, I’ll note that market returns are not guaranteed, and that inflation means that a million dollars more than 50 years from now will be worth a lot less than it’s worth now. Still, it’ll be a very hefty contribution toward a comfortable retirement for your kid, costing you less than $20,000. That means you can give her a boost that’s comparable if not greater than paying for her college, for less than the total cost of attendance at the University of Maryland for a single year. I think that’s a great addition to putting your kid through college, don’t you?

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Comments (2)

  • P
    • 2017-12-28 09:47:27

    What a fun read, thank you for posting it! Even if it yields less than a million, the combined effort makes for a positive memory to share with your offspring :) Cheers and best wishes for the new year!

    • O
      Opher  in reply to Pete
      • 2017-12-28 15:23:01

      Thanks Pete. I completely agree. Teaching our kids financial literacy is so important to their success, and this hits several aspects. It teaches them to accept delayed gratification to an extent because you only match them partially. It teaches them to save and invest for the future in general and for retirement in particular, while they have such a long time to benefit from compounding. Finally, you can research investment options together, teaching them how to pick a good mutual fund for the long haul (and if you don't know how, you can learn together - I'd highly recommend starting with the Morningstar Mutual Fund Directory, which you can find free in most public libraries, or subscribe online for a fee).

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