You want your child to earn some cash and learn financial responsibility? That’s great. But getting your kids to work accomplishes more than just keeping her out of trouble or generating some mall money. In fact, there are some significant tax advantages for both of you that every fiscally savvy family should know.
My first paying job, believe it or not, was as an Avon Lady. Long before my mother would allow me to wear makeup, she let me take over the sales territory for the retiring professional who sold cosmetics to the fashionable ladies in our apartment complex. Thinking back, it was a perfect solution for me—it taught me a lot about money, marketing, and interpersonal skills. (As a shy child, talking to people was tantamount to jumping off a cliff.) It kept my mind off the difficulties of growing up in a divorced home, and we needed the money. By the time I was 12 years old, I was buying most of my own clothes and school supplies, and was on my way to saving for a big college tab. The wonderful ladies of the Thimble Isle Apartments took me as seriously as they would someone who actually knew how to put on mascara. I still love them for it.
It was good for me and great for my mom. Will it be a positive experience for your family? Most folks report that there is nothing but good news when kids take on responsibilities for which they will be paid. Professional development, people skills, personal confidence, and an appreciation of what it takes to earn money are just some of the benefits, but there are also some financial advantages to encouraging an entrepreneurial child that may benefit the entire family unit. (As usual, that means taxes.)
Crunching the Numbers
For kids who work, wages up to $5,350 are free from federal income taxes (as of 2008). This is very nice. Here’s something even nicer—if you hire your children to do either domestic work (like cleaning or babysitting) or to work in an established small business, you don’t have to withhold Social Security or Medicare taxes on their wages. Don’t think that’s a coup? Ask former Attorney General nominees Zoe Baird and Kimba Woods how they feel about it. Both talented women came under fire for failing to pay Social Security taxes for their domestic help, who happened to be undocumented immigrants. If only they had adopted them first. (Actually, this exemption applies to kids under 21 who work around the house, and kids under 18 if they work in a family business.) Sock away the savings on taxes into an investment account for you or your kids. A disciplined approach can take the sting out of the expensive prospect of feeding and educating your children.
But the advantages don’t stop there; let’s dig a little deeper. Let’s say that you are self-employed as a medical claims processor. You have a small office and you hire your two kids to help out. They file, answer phones, run errands, type, and provide extra administrative support. In addition to teaching your kids responsibility and giving them valuable experience, you are also shifting income to your family members and legally lowering your tax burden. (This will work as long as your kids are under 18 and you’re not incorporated.) Hey, it’s not the Cayman Islands, but can be a tremendous help.
Let’s further say that you are in the 31 percent tax bracket. You pay each child $10,000 a year for their efforts, a total of $20,000. You insist that each child establish an IRA for themselves, and deposit the maximum of $2,000 in each account. That lowers their income to $8,000 each, which is further reduced by the standard deduction of $4,550. Each child, then, owes tax on $3,450. At 15 percent tax rate, they’ll owe only $517 each, or $1,035 total. Here’s where the savings come in. If you had not paid your children for the extra work, you would have paid taxes on that $20,000 income, which at 31 percent, is $6,200. Big difference. After paying the lower tax bill of $1,035, you have just saved yourself $5,165.
This quick and dirty demonstration doesn’t include the savings in FICA that come with lower income, nor the costs saved on childcare, since you now know where your kids are. As in any real life scenario, there are many variables to consider, and you should absolutely seek individualized advice. But, you get the picture: With a little finagling, hiring your kids can be a financial windfall for all of you. And, oddly enough, the IRS has approved hiring children as young as seven. Go figure. (Contact your state’s Department of Labor for the specific rules in your state.)
The picture only gets brighter. Once your kids establish some income, consider it the perfect time to start a retirement program. Yes, a retirement program. Traditional IRAs are a fine choice, if you want the tax deduction, as in the previous example. Either way, you’ve got the gift of time on your side—$200 invested today and left to compound for 50 years at 10 percent interest will grow to $54,000, give or take. If you add $2,000 for three years and let it grow for 50 years at the same rate, your young retiree would get $237,000 at the end of the exercise. Now, if you managed to add $2,000 a year for ten years, and then let it compound for 50 years, your child would enjoy $836,000 upon retirement. And, if he did his job and continued to add cash to his own account, he’d become even wealthier. Since IRA money can be used, in certain circumstances, to pay school loans and to provide a down payment for a first home, it’s not such an abstract concept.
If you don’t need the deduction, then Roth IRAs can be ideal for kids and teens, since the money grows tax-free. Crunch your personal numbers with your accountant and your kids to make the best choice for your family.