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Article:
Roth IRAs for Kids:
The Three Types of Income
By Hannah McMunn
Most kids have little concept of “income”, and do not know there are three kinds: earned (active) income, portfolio income and passive income. A kid needs earned income to start and fund a Roth IRA, but once earned income has been invested in the Roth IRA, the funds can be reinvested in the other two kinds of income.
Earned Income can be W-2 income or self-employment income. W-2 income is earned from an employer who withholds federal and state income taxes and FICA (Social Security and Medicare) -- and reports all that to both the Internal Revenue Service and to you on a W-2 tax form. The other kind is self-employment income where we are “independent contractors” running our own businesses and paying our own income and self-employment taxes via 1040 tax forms.
Portfolio Income is money earned from investments, dividends, interest, royalties and capital gains and will come from sources such as stocks, bonds, mutual funds, etc. The name derives from the old practice of keeping records of these investments in a portfolio (something like a briefcase or accordion folder).
Passive Income is defined by the Internal Revenue Service as "trade or business activities in which you do not materially participate," such as limited partnerships. Consider the following example. My brother wants to start a lemonade stand, and even though I will not work at his business, in return for my investing some seed money – for start-up expenses – my brother will give me half his profits. In this scenario, my brother is the General Partner and I am a Limited Partner. His income is Earned Income and mine is Passive Income.
Despite the possible confusion between Portfolio Income and Passive Income, what is critical for kids to know is that we cannot rely solely on Earned Income. Sooner or later we will retire, have health problems, and/or for other reasons no longer work. When the Earned Income ceases, we will be reliant on social service programs and, if we have had foresight, we will continue to benefit from our Portfolio and Passive Income.
To get our financial start in life, we need Earned Income, but to get a financial head-start we need to begin a disciplined conversion of some of that Earned Income into Portfolio and Passive Income. The best way to do this is to open a Roth IRA with Earned Income, and invest our Roth IRAs in Passive and Portfolio Income investment options. That process helps us diversify our financial base and gives us financial security long after our Earned Income ceases.
*Hannah was 16 when this article was written during the spring of 2011.
© 2011, IRAKids.com. All rights reserved.
*Hannah was 16 when this article was written during the spring of 2011.
© 2011, IRAKids.com. All rights reserved.
Roth IRAs for Kids: The Three Types of Income by Hannah McMunn, describes the three kinds of income: earned (active) income, passive income, and portfolio income. She defines earned income and notes that only earned income can be used to open Roth IRAs. However once the funds are in the Roth, those funds will be invested in portfolio investments such as stocks, bonds, mutual funds, etc. and passive income investments such as limited partnerships. She explains that our earned income will cease someday, whether through retirement, illness, or loss of employment – at which point we will be dependent on income from the other two sources. For a financial head start in life, kids must begin a systematic program of converting earned income into portfolio and passive income.
This article may be reused freely for educational purposes and may even be reprinted in other print publications (e.g., credit union newsletters) to encourage to start their Roth IRAs as soon as the kids have earned income. This article may not be sold or included in a publication that is to be sold. This article may not be loaded on other websites, but the abstract may be used and/or the articles may be summarized on other websites. In all cases, the author and the IRAKids.com website must be credited with authorship, and links should be provided back to the IRAKids.com website. For other uses of this article, please contact IRAKids.com.
For additional articles on Roth IRAs for Kids, which may be reused according to the “Guidelines” noted above, please see Articles by Hannah on Roth IRAs -- for Free Reuse Elsewhere.