Summer jobs remain an effective way for kids to learn about fiscal responsibility, save for college or even retirement, and supplement their spending money for the next school year. If you’re a Maine business owner, think about hiring your child or grandchild as a legitimate employee. Under the Tax Cuts and Jobs Act (TCJA) it can be a smart tax-saving strategy for both them and you.
Once you officially hire your child, your company gets a business tax deduction for employee wage expenses. This deduction ends up reducing your federal income tax bill, your self-employment tax bill (if applicable) and your state income tax bill.
And if the following conditions are met, your child’s wages are also exempt from Social Security, Medicare, and FUTA taxes:
- Your business operates as a sole proprietorship, a single-member limited liability company (LLC) that is treated as a sole proprietorship for tax purposes, a husband-wife partnership, or an LLC that is treated as a husband-wife partnership.
- Your child is under age 18 (or under age 21 in the case of the FUTA tax exemption).
- Your child is a legitimate part-time or full-time employee of the business.
Unfortunately, there’s no federal payroll tax break for hiring your offspring if your business is set up as an S or C corporation. For corporations, Junior’s wages will be subject to Social Security, Medicare and FUTA taxes as they would be for all your other employees.
There are still tax breaks available though. Your child’s wages can be deducted as a business expense on your corporation’s tax return. And thanks to the TCJA, your employed-by-you child can use their standard deduction to shelter up to $12,000 of their 2018 wages from the federal income tax. For 2017, the standard deduction was only $6,350. The TCJA has nearly doubled it through 2025, making the hire-your-kid strategy even better than it was before.
Important note: For an unmarried dependent child with earned income, the 2018 standard deduction is the greater of 1) $1,050 or 2) earned income + $350 but no more than $12,000.
In other words, for 2018, Junior will owe nothing in federal taxes on the first $12,000 of wages, unless he or she has income from other sources. This gives them the flexibility to save some of the wages and possibly contribute money to a Roth IRA or put it into their college fund.
The Roth Angle
The lone tax-law requirement for your children to make annual Roth IRA contributions is having earned income for the year that at least equals the amount contributed for that year. Age is completely irrelevant. Thus, if your child earns any money from a summer job or part-time work after school, they are able to make a Roth contribution for that year.
For the 2018 tax year, a working child can contribute the lesser of:
- Their earned income, or
While both Roth IRAs and traditional deductible IRAs have the same $5,500 contribution limit, the Roth option tends to make more sense for young people. Why? The 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. Roth earnings, however, can not be withdrawn tax-free before age 59½.
Compare this to deductible contributions your child makes to a traditional IRA where any subsequent withdrawals need to be included in gross income. Even worse, withdrawals from a traditional IRA before age 59½ will be hit with a 10% early withdrawal penalty tax unless an exception applies. (One of which is to pay for qualified higher-education expenses.)
Important note: While your child can withdraw Roth contributions without any unfavorable federal income tax consequences, the superior strategy is to leave the Roth account balance untouched until retirement (or beyond) in order to accrue a larger federal-income-tax-free sum.
Modest Contributions Can Add Up
Making Roth contributions for just a few years in their teens, kids can potentially accumulate a good-sized nest egg by retirement age. Of course, realistically speaking, most kids won’t be inclined to contribute the $5,500 annual maximum even if they have enough earnings to do so. However, if you can talk your teenage into contributing a meaningful amount, here’s what could happen:
Taylor the Teenager contributes $1,000 to a Roth IRA at the end of each year for four years (ages 15 through 18). If we assume a 5% annual rate of return, that $4,000 Roth account would be worth about $33,000 in 45 years when Taylor is 60 years old. If you assume a more-optimistic 8% return, the account would grow to about $114,000 in 45 years.
If Taylor’s parent could convince them to contribute $2,500 each year for those four years, and we assume an 8% rate of return, the Roth account would be worth a whopping $285,000 in 45 years. Worth making a few cutbacks in the present?
Tax Deductions for Traditional IRA Contributions
Aren’t the tax deductions for traditional IRA contributions an advantage over to contributing to Roth IRAs? While it is true that they won’t be able to write off Roth contributions, your child probably won’t get any meaningful tax breaks from the contribution to a traditional IRA either. That’s because, as mentioned above, an unmarried dependent child’s standard deduction automatically shelters up to $12,000 of 2018 earned income from federal income tax. Plus, any income beyond the $12,000 will almost certainly be taxed at very low rates.
So, unless the child has enough taxable income to owe a significant amount of tax, the theoretical advantage of being able to deduct traditional IRA contributions is just theoretical. And since that’s the only advantage a traditional IRA has over a Roth account, the Roth option almost always comes out on top for children.
Tax-Savvy Parents Raise Tax-Savvy Kids
Hiring your child can be a tax-smart idea for both of you. Remember though, that their wages must be realistic for the work performed. So, this strategy works best with teenage children to whom you can assign meaningful work. Maintain the same records as for all other employees to verify hours worked and duties performed (such as timesheets and job descriptions), and issue your child a W-2, as you would for your other employees.
And once they’ve earned some money, encouraging them to make Roth IRA contributions is a great way to introduce the ideas of investing for the future and tax planning. It’s never too early for children to learn about taxes and how to legally minimize or avoid them.