The 401(k) has become the go-to retirement plan for many Americans and continues to gain traction. The flexibility, tax savings and scale of 401(k) plans have made it attractive to employers and employees alike. But A 401(k) plan doesn’t need to be just for large corporations.
It can be used to help small business owners save for their future in a tax-advantaged way and allow minor children to participate. You read that correctly – even your minor children could participate in a 401(k).
How can a minor save for retirement in a 401(k)? The long answer is complex, as is the case with many things in the tax and legal world of retirement plans.
Ultimately, there is no too-young age restriction under Internal Revenue Code section 401(a), which sets the requirements for a tax-qualified plan, or under the Employee Retirement Income Security Act (ERISA) of 1974. However, other constraints like plan design, income limits and testing rules could make it impractical or impossible for a minor to participate in a 401(k).
A common misunderstanding with 401(k)s is that there’s a minimum age of 21. The minimum-participation rules state that a plan must not impose a minimum age condition beyond 21. But nothing in federal law precludes setting a plan’s minimum age at a younger age. These choices are ultimately up to the plan’s sponsor.
So what does this all mean with regard to minors? Plans don’t have to allow someone under age 21 to participate. The minimum participation rules don’t prohibit when someone can join, but rather sets a minimum requirement for when a plan must let someone participate. Federal law doesn’t set a required minimum age you must reach in order to participate in a 401(k).
However, many plans put an age condition in the plan document. An IRS interim report on 401(k)s found that 64% of reviewed plans had a minimum participation age of 21. Another 4% of plans had a minimum age of 19 or 20; 13% set the age at age 18; and roughly 20% had no minimum age requirement at all.
This means that roughly 80%of plans don’t allow minors to participate by setting a minimum age requirement at age 18 or higher. However, that leaves about 20% or roughly one out of every five plans open to allowing minors to participate.
Now, there is concern about state laws regarding minors. In most states, the age of competence is 18. I have seen some arguments that minors can’t enter into a contract to defer or participate in a 401(k). This misstates the common law about contracting under the age of majority. Upon reaching the state’s age of competence, individuals can disaffirm or get out of the contract. However, ERISA section 514(a) preempts state laws that relate to an employee benefit plan, and might supersede a state law that otherwise could allow a participant to disaffirm an election made under an ERISA-governed employee benefit plan. Or, a cautious employer and plan administrator might ask that a minor’s conservator or guardian (often, a parent as a natural guardian) approve the minor’s acts.
Usually, this isn’t a practical problem. Retirement plans lawyer Peter Gulia, the shareholder of Fiduciary Guidance Counsel, explains why. “Not many big-business employers have more than a few employees younger than 18 without excluding them through an age, service, or other condition. But many small-business employers write a plan with no minimum age, so business owners’ children not only can earn wages but also get retirement benefits,” Guila told me. “If mom’s business gives her son a paycheck, a tax-favored savings opportunity, and a matching contribution, how likely is it that a first-year college kid will disaffirm his teenage years’ 401(k) contributions? And if he did, mom could get back her matching contributions and the investment gains on them.” So, while a state’s law of contracts could still be of some concern, it need not practically preclude a minor from participating in a 401(k) plan.
There is still one more point to consider. The minor has to be employed and receive reasonable compensation for the services they provide to the employer. Some states do limit jobs a minor can have. Clerical or farming work for a child’s parent is usually acceptable.
Another strategy people employ is paying their children for modeling services and using their photographs on websites and other marketing materials. Obviously, this would still require reasonable compensation. A business owner might check with a lawyer and CPA to ensure it’s done right.
Minors wouldn’t be excluded from annual 401(k) testing requirements like contribution limits and salary-deferral limits. There are instances where adding a minor child of the plan owner could present complications for the plan, depending on how the plan is set up, its goals and who the other participants in the plan are.
For instance, a minor participant can only have a salary deferral up to $19,500 in 2021, and the total amount that goes into the participant’s account per year cannot exceed 100% of the participant’s compensation or $58,000 for anyone under age 50 in 2021. So, if a minor is earning $15,000 a year and wants to defer the whole amount, they could, but they couldn’t receive any other real matching contributions. Additionally, employers can have limits on how much they can contribute and deduct into a plan per year, typically up to 25% of compensation paid.
When would it make sense to let a minor participate in a 401(k)? For family-owned firms, it can be a smart strategy to allow their minor children who work in the business to participate in a 401(k). It could allow the minor to defer his or her salary into the 401(k) and allow the employer to also contribute to the minor’s account through a match or non-elective provision. It might also be wise to consider allowing Roth savings inside the 401(k).
The child’s tax rate could be extremely low, allowing him or her to save in an after-tax fashion with valuable long-term tax and investment benefits.
If allowing a minor to participate in a family-dominated 401(k) seems like too much complexity, effort, risk or cost, you can still allow them to work in the family business, generate earned income and fund a traditional or Roth IRA. This minor IRA strategy is much more established and pervasive in the financial planning world. In fact, many large custodians provide options for parents, grandparents, or any adult to set up an account for a minor child who has earned income. The adult can manage the account until the child reaches the required age in which the account must be turned over to the child. (Again the age varies by state.)
Getting your children into a retirement account at such an early age sets them up for long-term savings, investing, and retirement planning success.