Using the New Tax Law to Save for Your Child’s Future
The Tax Cuts and Jobs Act passed by Congress in December brought many changes to the income tax code. Perhaps none has been more widely covered than the increase to the federal standard deduction. While this increase offers a limited benefit to high income taxpayers, it does offer an opportunity for parents seeking to pass down wealth to their child.
To take advantage of this planning opportunity, you just need to hire your kid and become their boss!
The tax act nearly doubled an individual’s standard deduction to $12,000. This increase provides an opportunity for your child to set aside tax-free earnings in retirement accounts. They will not owe federal income tax on the first $12,000 that they earn — this is true whether you’re the employer or someone else.
If you are the employer, it may seem that you are simply transferring money from your pocket to your child’s. However, this strategy can be used in lieu of or in conjunction with annual exclusion gifts, and it allows you to begin funding an Individual Retirement Arrangement (IRA) account now. These retirement accounts will grow tax-free for many decades. As their employer, you could even offer to facilitate those deposits on their behalf. Additionally, some college financial planning strategies open up when income is diverted into retirement savings.
From parent to employer
If you own a business, consider hiring your child to perform some menial tasks for you. Compensation paid to a child employee under age 18 by an unincorporated business (such as a sole proprietorship or partnership between spouses) is not subject to employment taxes if the business is entirely owned by the parents. Also, federal Fair Labor Standards Act minimum age requirements also do not apply in most cases for children under 18, but be sure to consult your state’s child labor laws.
Depending on their age, you can assign them office or cleaning tasks. Just make sure that the employment responsibilities are age-appropriate — a 5-year-old cannot be expected to enter data in QuickBooks! One of your authors remembers being paid to stand in long lines at the country recorder’s office to help the paralegals at his father’s real estate law practice record property transfers. Of course, if your children are a little older, you can offer them some truly beneficial work experience that will build their resumé or prepare them for a future leadership role within your company. This would also keep your payroll dollars inside the family.
Even if you don’t own a business, you can still pay your child to perform chores and responsibilities around the home. For household tasks, your child’s compensation is not subject to the normal wage withholding until the age of 21.
A W-2 form is required whether or not you own a business in order to document that the child is eligible to make IRA contributions and that the money is not a gift. But wages paid to a minor child are subject to income taxes only if above the $12,000 standard deduction. Importantly, they are excluded from Social Security, Medicare and employer-paid federal unemployment taxes. In addition, California law excludes this income from that state’s unemployment insurance, employment training tax and State Disability Insurance taxes. Ask your tax attorney about state tax laws for minors in your state.
Saving for the future
To kick-start the funding of their retirement and education goals, you could advise your child to use these earnings to fund a Roth IRA. Income grows tax free when used for retirement.
The growth potential is far greater if they start saving for retirement now. A child who saves $5,000 per year between the ages of 15 and 24 will have approximately $1.7 million at age 65 (when invested at a consistent 8% per year). If that same child didn’t start saving $5,000 per year until age 25, and kept contributing that amount for 40 years, their account will grow to only $1.4 million.
And unlike a 529 College Savings Plan, the value of a Roth IRA is generally ignored for determining financial aid eligibility. Diverting some of your post-tax earnings into your child’s Roth account ahead of college might reduce your contribution toward college costs.
Hiring your child opens up new wealth transfer options, helps your child get a head start on long-term financial planning, and enables them to get some important work skills at an early age. And who knows? Maybe they’ll even listen to you better as your employee than as your kid.