Most people with children take into account the financial implications of their care — for instance, they prioritize paying for their children’s food, shelter, clothing and education. But they might not even consider the fact that taxes can affect minors, too. Parents should familiarize themselves with the tax implications of the “kiddie tax,” hiring their children and setting up IRAs for working teens.
How the Kiddie Tax Works
The kiddie tax was created to prevent parents in high income tax brackets from shifting unearned income, such as dividends, interest and capital gains to their kids, who usually enjoy lower income tax rates.
The kiddie tax is a tax on unearned income paid to children under age 19 and full-time college students under the age of 24. For 2017, the first $1,050 of such income is tax free, the second $1,050 is taxed to the child at his/her tax rate and all unearned income over $2,100 is taxed at the parents’ tax rate. Any income your child has that’s earned (wages, salaries or tips) is taxed at their tax rate.
The kiddie tax can be avoided if college students under age 24 or children ages 19 to 23 who are not full-time students provide over half of their own support from their own earned income. In this case, the child’s unearned income would be based on the child’s tax rates, not the parent’s rates under the kiddie tax rules. This is known as the support test for the kiddie tax and should not be confused with the support test for the personal exemption which allows “support” to include both earned and unearned income. A student can technically be subject to the kiddie tax while at the same time “pass” the support test to claim themselves as a dependent on their own tax return.
If your children fall within the kiddie tax rules, there is another way to stay within the limit — give your child investments that appreciate over time but don’t generate much or any taxable income until they’re sold (for example: growth stocks). If you wait until after the child turns 24 to sell, the kiddie tax will not apply.
If the child’s unearned income in 2017 is more than $2,100 but less than $10,500 and was not subject to backup withholding and no estimated payments were made, the parents can elect to include the income on their tax return and avoid filing a return for the child. Keep in mind that increasing parents’ income could impact certain deductions or credits based on AGI. It may also work to the parent’s advantage if they can deduct more investment interest expense because of the child’s income inclusion.
Having Children Work for You
Along with the other benefits of working for a family business, having children work for their parents offers tax advantages. However, parents considering this must follow a few guidelines. For example, the child should be old enough to handle the responsibilities assigned. He or she should perform real tasks and be paid an appropriate wage.
If you’re a sole proprietor or single-member LLC, or run a spousal partnership and you hire your children under 18 years old to work in the business, you can pay your child for the work done without having to withhold Social Security, Medicare or unemployment taxes.
If the business is a corporation or estate, however, the child’s wages are subject to income tax withholding, as well as Social Security, Medicare and federal unemployment taxes. That’s true even if the child’s parent controls the corporation.
Even if your children don’t qualify for the favorable payroll and unemployment tax treatment described above, hiring them may still work in your family’s favor. Wages you pay your children are a tax-deductible business expense, which lowers your company’s net income and your total tax liability. Most likely, your kids are in a lower tax bracket than you. If their income doesn’t exceed the standard deduction, it’s possible they won’t owe any income tax on their wages at all. Depending on your tax bracket, you could save up to 39.6 percent on wages paid.
The tax benefits for hiring your kids can be substantial, which means there’s lots of potential for abuse. There’s nothing wrong with employing your kids, but you may face additional scrutiny from the IRS if you do. It is recommended to maintain payroll documentation and records to prove that your children are bona fide employees. Be realistic about their skills and compensation as well. The IRS isn’t likely to believe that a 14-year-old is doing your accounting, and it will keep an eye out for an unreasonably high pay rate.
Not Too Early to Start Saving
Although retirement is decades away for teenagers, they’re not too young to start saving for it. Given the time value of money, even modest amounts put away from part-time jobs can eventually grow into a sizable sum by the time children are ready to withdraw the funds. Consider this: a single $1,000 IRA contribution made at age 10 could grow to $11,467 over 50 years, assuming a 5% average annual growth rate. Contribute an additional $50 each month, and the account might grow to $137,076 (with a 5% growth rate). As children make more money and eventually become adult earners, their annual contributions are likely to be higher, and the IRA could grow correspondingly. Setting aside money each month or year for an IRA – even if the contributions are small – helps your child develop awareness and healthy financial habits.
Another benefit of IRAs is that your child may be able to tap into the account for qualified higher education expenses and up to $10,000 towards a down payment on a first home without penalty. With a Roth IRA, you can withdraw any contributions, but not the investment earnings, for any reason without tax or penalty.
Keep in mind that, in order to contribute to an IRA, the child must have earned income, either salary, wages or other compensation. Roth IRAs will be the best choice for minors, especially in situations where the child’s income isn’t enough to generate any income tax. For 2017, contributions, whether to a Roth or traditional IRA, are limited to the lesser of $5,500 or their taxable compensation for the year.
Typically, the account will need to be opened and held by an adult in the name of the child. When the child reaches age 18 or 21, depending on the state, he or she can assume ownership.
Navigating the System
There is a lot of nuance to the tax issues surrounding children. Your tax professional will be able to provide a road map for navigating the labyrinth.