It’s summer, and that means it’s time for kids to have jobs. Hiring your child as a legitimate employee of your business can be a great tax-saving strategy. Here’s the deal.
Tax advantages for your kid
Say you operate your business as a sole proprietorship, as a single-member LLC that is treated as a sole proprietorship for tax purposes, as a husband-wife partnership, or as an LLC that is treated as a husband-wife partnership. Great! That means you can hire your under-age-18 child (as a legitimate employee) and his or her wages will be exempt from Social Security tax, Medicare tax, and federal unemployment (FUTA) tax. In fact, the FUTA tax exemption lasts until your employee-child reaches age 21. You can hire your child part-time, full-time, or whatever works for you and the kid.
Thanks to the Tax Cuts and Jobs Act (TCJA), your employee-child can use his or her standard deduction to shelter up to $12,000 of 2018 wages paid by your business from the federal income tax. For 2017, the standard deduction was only $6,350, but the TCJA nearly doubled it. So under the new law, your child can shelter almost twice as much wage income with the increased standard deduction. That makes hiring your kid a better idea than ever.
Bottom Line: For 2018, your child will owe nothing to the Feds on the first $12,000 of wages, unless the kid has income from other sources. Your kid can then set aside some or all of the wages and contribute money to a Roth IRA (more on that later) or a college fund.
Tax advantages for you
When you hire your child, you get a business tax deduction (for employee wage expense) for money you might have just shoveled out to the kid anyway. The deduction reduces your federal income tax bill, your self-employment tax bill (if applicable), and your state income tax bill (if applicable).
If your business is incorporated
What if you operate your business as a corporation? In that case, your child’s wages are subject to Social Security, Medicare, and FUTA taxes just like for any other employee. However, multiple tax breaks are still available. You can deduct your child’s wages as a business expense on your corporation’s tax return; you child can shelter the wages sheltered from federal income tax with his or her standard deduction ($12,000 for 2018), and your child can use the wages to fund annual Roth IRA contributions or save for college.
The Roth IRA angle
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 is contributed for that year. Age is completely 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.
Specifically, for the 2018 tax year, a working child can contribute the lesser of: (1) his or her earned income or (2) $5,500. While the same $5,500 contribution limit applies equally to Roth IRAs and traditional deductible IRAs, the Roth option is usually better for kids for the reasons explained below.
Modest contributions to kid’s Roth IRA can amount to big bucks by retirement age
By making Roth contributions for just a few years during teenager-hood, your child can potentially accumulate quite a bit of money by retirement age. Realistically, however, most kids won’t be willing to contribute the $5,500 annual maximum even when they have enough earnings to do so. Try talking a teenager into saving a significant amount of money instead of spending it all at the mall. Good luck! So parents must be satisfied if they can convince children to contribute at least a meaningful amount each year. Here’s what could happen.
• Say your 15-year-old contributes $1,000 to a Roth IRA at the end of each year for four years. Assuming a 5% annual rate of return, the Roth account would be worth about $33,000 in 45 years when the “kid” is 60 years old. If you assume a more-optimistic 8% return, the account would be worth about $114,000 in 45 years.
• Say the kid contributes $1,500 at the end of each of the four years. Now the Roth account would be worth about $49,000 in 45 years, assuming a 5% rate of return. With an 8% return, it would be worth about $171,000.
• Say the kid contributes $2,500 at the end of each of the four years. Assuming a 5% return, the Roth account would be worth about $82,000 in 45 years. Assuming an 8% return, the account value jumps to a whopping $285,000. Wow!
You get the idea. With relatively modest annual contributions for just a few years, Roth IRAs can be worth eye-popping amounts by the time the “kid” approaches retirement age.
Why the Roth IRA is usually the better IRA option
For a child, contributing to a Roth IRA is usually a much better idea than contributing to a traditional deductible IRA for several reasons. First, 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. However, Roth earnings generally cannot be withdrawn tax-free before age 59½. In contrast, if your child makes deductible contributions to a traditional IRA, any subsequent withdrawals must be included in gross income. Even worse, traditional IRA withdrawals taken before age 59½ will be hit with a 10% early withdrawal penalty tax unless an exception applies (one exception is to pay for qualified higher-education expenses).
Key Point: 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 age in order to accumulate a larger federal-income-tax-free sum.
What about tax deductions for traditional IRA contributions you ask? Isn’t that an advantage compared to Roth IRAs? Good questions. As you know, there are no write-offs for Roth contributions, but your child probably won’t get any meaningful write-offs from contributing to a traditional IRA either. That’s because, as explained earlier, an unmarried dependent child’s standard deduction will automatically shelter up to $12,000 of 2018 earned income from federal income tax. Any additional income will almost certainly be taxed at very low rates. So unless the child has enough taxable income to owe a significant amount of tax (not likely), the theoretical advantage of being able to deduct traditional IRA contributions is mostly or entirely worthless. Since that’s the only advantage a traditional IRA has over a Roth account, the Roth option almost always comes out on top.
The bottom line
Hiring your child can be a tax-smart idea. Remember, however, that the child’s wages must be reasonable for the work performed. So the hire-the-kid strategy works best with teenage children who can be assigned meaningful tasks. Keep the same records as for any other employee to substantiate hours worked and duties performed (e.g., timesheets and job descriptions), and issue your child an annual Form W-2 just like any other employee.