This idea not only provides a business deduction to your business and gives your child spending money, it can be used as a way for reallocating income that the child can then use to save for college. It also provides “earned” income on which that child can then fund IRAs with. Starting either a Traditional or ROTH IRA that starts earning retirement income for your child while they are still in their teens gives them enormous potential for compounding money over 4 to 5 decades. Long before they are of retirement age, they could already have quite the nest egg that would provide a lot of security for them. One $5,500 IRA contribution earning a meager 4% over 50 years would grow to $40,000 (only $5,500 of your money and $34,500 earning over the years for just sitting there). If you could average 8% over that same period, that amount would grow to $258,000! Just think what could be set aside for them if you funded an IRA for them every year for the 8 years they are in high school and college.
Since the burden of retirement savings is more and more being placed on the individual to save for themselves, getting this kind of jump-start would be life-changing for them.
Even if you are planning on paying for your children’s college education, you can still use this tool with an understanding with your child, that the bulk of what you pay them in wages is being set aside to pay for higher education expenses.
To be deductible, payments to children must be reasonable and must be for services that the child actually performs. Accurate record keeping is essential in these situations. The work performed must be of the type that would generate ordinary and necessary business expenses and must be appropriate for the age of the child. You cannot hire one child to babysit another or mow the lawn. The job duties must be the kind that are normally required by your business operation; filing, copying, answering phones are all valid duties. You can compensate your child at the same rate that you would pay anyone else to perform these tasks.
If you are unincorporated, wages paid to your child under the age of 18 are not subject to FICA or FUTA, another tax savings. In 2013, you could have paid your child $11,600 which is the amount of the standard deduction they are allowed and $5,500 they could fund in an IRA and there would have been no tax of any kind on that income. If you are in the 33% bracket, that shift of income to your child would save you $3,828. That is a significant savings. If you are incorporated, then your child would be treated like any other employee and would be subject to withholding and FICA, but it can still make sense even in these situations.
If your income bracket reduces your ability to claim the personal exemption for your child, then you may want them to file separately from you to better utilize the personal exemption. Or you can still claim your child as a dependent on your tax return, but their standard deduction would be $1,150 instead of the $6,100.
Either way, this strategy can work for many self-employed people, partnerships made up of only the parents and S Corporations (subject to regular payroll rules)
My seventeen year old is having a hard time finding a summer job, so I am hiring her to get my filing current. I let her keep half of her earnings and I put the other half in her savings account so she will have spending money for college, which is one year away. With my own money, I am funding another IRA for her (I have done this in the past with 100% of her earnings) and I am hoping that I am setting her up with some financial security that will serve her well in retirement or will help her should she struggle financially in the future.
Consider this strategy for tax savings, opportunities for retirement savings, funding college, giving your child new skills, spending money, learning responsibility, etc. There is really nothing but great things that can come from this idea.
Consult with your CPA to get specifics on how this strategy can work for your particular situation and explore the many ways this can be a great idea for your family.