Money Maven: Putting Your Kids to Work

By Sheryl Rowling

SAN DIEGO —  Q:   My teenage daughter is planning to get a job this summer.  Do you have any advice for her?

A:        Your daughter should expect income tax withholding on her wages. She might be able to claim exempt status if she had no income tax liability for last year, and expects to have none for this year.

If your daughter will earn enough money to pay income taxes, she might want to make a deductible IRA contribution of up to $5,000.  If she will pay little or no income taxes, she might want to make a non-deductible Roth IRA contribution of up to $5,000.  The Roth IRA will earn income tax-free and she will not pay any taxes when she eventually pulls the money out at retirement.  The power of compounding is incredible – if she contributes $5,000 at age 15 and the Roth earns 7% per year, she will have almost $150,000 at age 65.  And – all that growth is tax-free!

Q:        I have my own business.  Are there any benefits to hiring my daughter in my business?

A:        By putting your daughter on the payroll, you can turn high-taxed income into tax-free or low-taxed income, achieve social security tax savings (depending on how your business is organized) and even make retirement plan contributions for her.  Here’s how:

Turning high-taxed income into tax-free or low-taxed income: You can turn some of your high-taxed income into tax-free or low-taxed income by shifting some of your business earnings to your daughter for services performed by her. The work done by your daughter must be legitimate, and the amount you pay must be reasonable.

For example, suppose your business is a sole proprietorship and you are in the 35% tax bracket for 2012. If you pay your daughter $5,950 during 2012, you will save $2,082.50 (35% of $5,950) in income taxes!  Your daughter will pay no taxes because she can use her standard deduction to completely shelter her earnings.

You can save an additional $1,750 in taxes for 2012 if your daughter earns an additional $5,000 from your business. She could shelter the additional amount from tax by making a tax-deductible contribution to her own IRA.

And family taxes are cut even if your daughter’s earnings exceed her standard deduction and IRA deduction. That’s because the unsheltered earnings will be taxed to her beginning at the lowest regular tax rate, instead of being taxed at your higher tax rate.

Keep in mind that bracket-shifting works even for your other children that might be under age 19 (or 24 if a full time student). The “kiddie tax” only applies to a younger child’s investment income in excess of $1,900 (for 2012) to be taxed at the parent’s marginal rate. It has no impact, however, on the child’s wages and other earned income, which can be sheltered by the child’s standard deduction.

Social security tax savings:  If your business is not incorporated, you can also save some self-employment (i.e., social security) tax dollars by shifting some of your earnings to your daughter. That’s because employment for FICA tax purposes doesn’t include services performed by a child under the age of 18 while employed by a parent. For example, let’s say you usually earn $65,000 from the business and you pay $5,950 to your daughter in 2012. Your self-employment income would be reduced by $5,950, saving $730 (not including the deduction for half of self-employment tax).

A similar but more liberal exemption applies for FUTA, which exempts earnings paid to your child under age 21.

Retirement benefits: Your business can also provide your daughter with retirement benefits. For example, if it has a simplified employee pension, a SEP contribution can be made for your daughter of up to 15% of her earnings. Your daughter’s participation in the SEP won’t prevent her from making tax-deductible IRA contributions as long as her adjusted gross income is below $58,000.

These rules are complicated, so be sure to consult your tax advisor for the particulars.

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Rowling is a certified public accountant, personal finance specialist, and principal of Rowling & Associates. She may be contacted at sheryl.rowling@sdjewishworld.com