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Starting Young

Ross Menke  |  December 14, 2018

I BEGAN WORKING for my father at age 12. He and his brothers run a sign manufacturing business that was co-founded in 1947 by my grandfather. The first few years, I cleaned pickup trucks, swept floors and took out the trash. When I got my driver’s license in high school, I started running errands for the business—better known as a gopher. As a finance major in college, I was able to work my way into the office, completing invoices, writing work orders and balancing the general ledger by hand. The lessons learned as I progressed through different jobs at the business are still valuable to me today.

Got your own business? The opportunity to employ your children is among the many potential benefits—and it isn’t just about developing a work ethic and teaching your kids to earn a dollar. There’s also the possibility of significant tax savings and the chance to get your children started as investors at a young age.

For this strategy to pass muster with the IRS, your children need to perform an actual service to the business and need to be paid a reasonable wage. Most likely, your kids have skills that you can leverage to modernize your business. Social media and online marketing come to mind. Other tasks include administrative or custodial work. Be sure to look up job or hourly rates for their position and document your findings. This will help in the event of an audit.

Intrigued? Use this five-step process to pay your kids for their services, maximize tax benefits and teach valuable investment lessons:

  1. Hire your children to work for you and pay them a fair wage. Ideally, they earn $12,000 or more in a calendar year.
  2. Your children each take 2018’s standard deduction of $12,000 when filing their taxes. This should reduce their taxable income to $0, unless they earn more than the standard deduction. In 2019, the standard deduction rises to $12,200.
  3. The $12,000 or so of tax-free earnings will eventually be sent to two accounts: a Roth IRA and a 529 college savings plan.
  4. In 2018, each child can contribute up to a $5,500 to a Roth IRA, which then grows tax-free. In 2019, the maximum contribution rises to $6,000.
  5. The remaining money will be gifted back to you, so you can make a contribution to their 529 plan. The 529 grows tax-deferred and withdrawals are tax-free when used for qualified higher education expenses.

As an added benefit, the $12,000 or so in wages you pay each child are tax-deductible to the business. This means that you personally avoid having to pay any corporate or income taxes on these dollars.

Your children will be exempt from paying Social Security and Medicare payroll taxes if your business is a sole proprietorship and if they’re under age 18. They are also exempt from payroll taxes if the business is a partnership and the only partners are the children’s parents.

What happens if your business is incorporated? Your children will need to pay payroll taxes like any other employee. But the benefits far outweigh the taxes owed.

Starting in 2018, the Child Tax Credit was increased to $2,000. You can claim the credit on your return, assuming your children continue to meet the requirements to be considered a dependent. If your child earns enough to provide half of their own support, they no longer qualify.

The tax savings for you are nice, but the early start to investing for your children is even better. Take the Roth IRA. Suppose they make contributions of $6,000 a year for six consecutive years. Result? After 45 years, they’d each have $350,000, assuming a 5% inflation-adjusted annual return.

Ross Menke is a certified financial planner and the founder of Lyndale Financial, a fee-only financial planning firm in Nashville, Tennessee. He strives to provide clear and concise advice, so his clients can achieve their life goals. Ross’s previous blogs include Money Date Night, That Extra Step and Keeping It Going. Follow Ross on Twitter @RossVMenke.

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