The most trending tax and financial industry issues.

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Lane Keeter, CPA

Partner: Tax Consulting, Estate Planning, and Heber Springs Managing Partner

Tax Benefits of Hiring Your Kiddos!

With summer in full swing, many kids are working or looking for summer work. If you have a business and have kids, there can be valuable benefits in hiring them to work for you; benefits both to them and you!

Summer jobs are a great way to teach financial responsibility and encourage children to save for college or retirement (yes, I said retirement), all the while giving them much desired spending money.

Hiring your own child or grandchild as a legitimate employee (in other words, they must do real work) can also be a smart tax-saving strategy for employee and employer alike.

When you hire your child, you get a tax deduction for the wages you pay. The deduction, of course, reduces your income tax bill. It may also lower your self-employment tax, if applicable to the business in question.

Here's a bonus - the child's wages will be exempt from Social Security, Medicare, and FUTA taxes if you run your business as:

  • A sole proprietorship,
  • A limited liability company (LLC) treated as a sole proprietorship for tax purposes,
  • A husband-wife partnership, or
  • A husband-wife LLC treated as a partnership for tax purposes.

To be eligible for this, the child must be under age 18 (or under 21 for the FUTA tax exemption).

Unfortunately, corporations are not eligible for this benefit, but are still eligible to take the income tax deduction.

Want some more gravy?

Under the new tax law, your employee-child can use his or her standard deduction to shelter up to $12,200 of 2019 wages paid by your business from federal income tax.

In other words, your child will owe nothing in federal taxes on the first $12,200 of wages, unless he or she has income from elsewhere. Your child can save some of the wages, and possibly even contribute money to a Roth IRA or put it into a college fund.

Let's take a look then at the Roth idea. The only tax-law requirement for your child to make annual Roth IRA contributions is having earned income for the year that at least equals what's contributed for that year. Age is irrelevant.

So, if your child earns some cash from a summer job or part-time work after school, he or she is entitled to make a Roth contribution for that year. For 2019, a working child can contribute the lesser of his/her earned income or $6,000.

While the same $6,000 contribution limit applies equally to Roth IRAs and traditional deductible IRAs, the Roth option usually makes more sense for young people. Why is that? 

For one, if your child doesn't have to pay income tax anyway because their income is too low, then making a deductible contribution is of no value to them, but will cost them tax later upon withdrawal as discussed below.

Also, your child can withdraw all or part of the annual Roth contributions without any federal income tax or penalty to pay for college or for any other reason. I emphasize the word "contributions" here because generally, Roth earnings can't be withdrawn tax-free before age 59Ω.

In contrast, if your child makes deductible contributions to a traditional IRA, withdrawals must be included in taxable income, and withdrawals taken before age 59Ω are hit with a 10% early withdrawal penalty unless an exception applies. One such exception is to pay for qualified higher-education expenses.

Piece of advice: Even though your child can withdraw Roth contributions without any adverse federal income tax consequences, the best strategy is to leave as much of the Roth account balance as possible untouched until retirement (or later) in order to accumulate a larger income-tax-free nest egg.

The cool thing is, by making Roth contributions for even just a few years, your child can potentially accumulate a significant retirement account. If you can talk your child into contributing a meaningful amount toward retirement, rather than spending it on clothes or the latest video game, here's what could happen.

Junior contributes $1,000 to a Roth IRA at the end of each year for, say, four years starting at age 15. At a 5% annual rate of return, the Roth account would be worth about $33,000 in 45 years when he is 60 years old. If you can get an 8% return, the account would be worth about $114,000 in 45 years. And if you could talk him into contributing $2,500 each year, his Roth account would be worth a whopping $285,000, assuming an 8% rate of return!

Realistically, most kids won't be willing to contribute the annual maximum even when they have enough earnings to do so. But here's a thought; how about an incentive to contribute? You could agree to match, as a gift, Junior's or Susie's contribution dollar for dollar up to the maximum annual amount, and really set him or her up for the future! It matters not where the money comes from.

Hiring your child can be a tax-smart idea. Remember though, the child's wages must be reasonable for the work performed. Keep the same records as for any other employee to substantiate hours worked and duties performed (such as timesheets and job descriptions), and issue your child a Form W-2, as you would for anyone else.

Encouraging your child to make Roth IRA contributions is a great way to introduce the ideas of saving money and investing for the future. It's also a great lesson in tax planning. It is never too soon for children to learn about taxes and how to legally reduce them.

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