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Financial Advisor Series: Save Money by Employing Your Kids

| June 19, 2018
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As Financial Advisors, we are often asked about developing financial planning strategies that shifts income to other members of the family, including children.  The new tax bill increased the standard deduction for single tax filers from $6,350 to $12,000. This will simplify taxes for many, with about 90% of tax filers expected to use the standard deduction in 2018. Prior to 2018 it was very attractive to shift income to your children under age 18. Now it becomes even more so, as it grants you the opportunity to save over $4,000 in taxes. The ability to maximize the tax savings is predicated on being a sole business owner, not including S or C corporations. While some of these benefits are still available with other business structures, there are more complexities involved.  It is always wise to consult your tax professional for specific advice.

Here’s how the strategy works:

  1. Parents aren’t required to withhold or pay Social Security and Medicare taxes for their children under age 18 as they would for other employees. As a result, money doesn’t get diluted as the children receive their paychecks. Again, this is only true for sole proprietorships or other solely owned business structures excluding S and C corporations.
  2. The standard deduction allows for a full salary of up to $12,000 to be paid to the child completely tax free. If this income were being paid to you at a 24% tax rate, the tax cost would be $2,880. If you are in a higher tax bracket you would save even more in taxes by paying the $12,000 to your qualifying child.
  3. There is no self-employment tax (15.3%) which is charged on these earnings when coming from a sole proprietorship or partnership, so you would see a savings of $1,836 ($12,000 x 15.3%).

With the total savings that you would get from these steps, you save $4,716 (or more, if your tax bracket is higher than 24%) on that money compared to taking it as part of your income. Of course, the income to the child has to be earned, but can be paid to them for clerical work or tasks that are legitimate business value adds.

Assuming that you manage to save $4,716 in taxes by paying your child, the question now becomes what to do with it the savings. There are two main financial planning opportunities resulting from this strategy:

  1. You (or your child) can begin to fund a traditional or Roth IRA. Now those funds (up to $5,500 per year, or the total earned by the child, whichever is less) can be invested for your child’s long-term benefit. A Roth IRA in this scenario is especially beneficial, as the contributions go in tax free, grow tax deferred, and the child can later in life withdraw both contributions and earnings tax free after they are 59 ½. Contributions (not earnings) can also be withdrawn to pay for college expenses without paying taxes or penalties on that money.  If you previously purchased a Florida prepaid plan this is a great tool that your child can tap for other expenses that aren’t covered under that plan.  In addition, it gives them an incentive to limit non-essential expenses so they can maintain a growing balance in their IRA.   
  2. This money is legally your child’s, with you as custodian. As such it cannot be used to pay for the normal expenses of raising your child. In many ways this can be a great tool to teach your children the value of money, and how to handle it. Paying for summer camps, birthday parties, toys, and other similar expenses with that money will help them learn valuable budgeting experience.

When employing these financial planning strategies, always work with your financial advisor and CPA to make sure that they fall within the rules and regulations of the IRS. If you’d like help in seeing how you could begin a similar strategy, or if you need help with any other financial issue, please visit our website at www.capanjax.com to schedule a free consultation with one of our Financial Advisors, or call us at 904-730-7433.

Disclaimer:  This content was developed from sources believed to be providing accurate information. The information in this material is not intended to provide legal or tax advice. You should consult your legal or tax advisor for information concerning your individual situation.

 

Sources:

https://www.aarp.org/money/taxes/info-2018/new-standard-deduction-fd.html

https://www.onefpa.org/journal/Pages/JUN18-Understanding-Taxation-of-Dependent-Childrens-Income-after-Tax-Reform.aspx

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