You’re newly self-employed, and your kids are out of school for the summer. Hmmm. Do you have one or more young ones who could do some useful work for your business? If so, hiring your kid — or several of your kids — can deliver some nice tax advantages. Because kids are leaving school and will probably be fully available for the next few months, this is a timely story. Forget about those swimming and tennis lessons you might have been thinking about. Put the darn kids to work. They need to learn about capitalism, and the sooner the better. Here’s what you need to know about the tax implications.
Tax advantages for your kid
You operate your business as a sole proprietorship, as a single-member LLC that’s 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.
Your dependent employee-child’s standard deduction can shelter up to $12,950 of 2022 wages received from your business from the federal income tax. Nice.
Bottom line: Your child will owe nothing to the Feds on the first $12,950 of wages, unless he or she has income from other sources. The 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 handed out to the kid anyway. The deduction reduces your federal income tax bill, your self-employment tax bill, 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; your child can shelter the wages from federal income tax with the $12,950 standard deduction; and your child can set aside some of the wages in a Roth IRA or college fund.
Playing the Roth IRA angle
The only tax-law requirement for your child to make an annual Roth IRA contribution 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.
For the 2022 tax year, your child can contribute the lesser of: (1) his or her earned income or (2) $6,000. While the same $6,000 contribution limit applies to a Roth IRA and a traditional deductible IRA, the Roth option is almost always better for kids for the reasons explained later.
Modest contributions to kid’s Roth IRA can really add up
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 $6,000 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. Good luck. So, you, as a realistic parent, must be satisfied if you can convince your child 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.
For kids, Roth IRAs are almost always better than traditional IRAs
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).
Important 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 question. 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 $12,950 of 2022 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 for kids.
The bottom line
As you can see, hiring your child can be a tax-smart idea. And it’s also probably much easier to hire a member of your family right now than to hire an outsider, given the tight labor market. Plus hiring your kid keeps more money in the household.
Remember, however, that the child’s wages must be reasonable for the work performed. So, the hire-your-kid strategy works best with teenage children who can be assigned meaningful tasks.
Keep the same records as you would for any other employee to substantiate hours worked and duties performed (e.g., timesheets and job descriptions). And be sure to issue your child a 2022 Form W-2 early next year, just as you would for any other employee.