There are significant tax savings when children work holding summer jobs. Especially if you have the opportunity to employ your child for your small business.
Children who are dependents of their parents are subject to what is commonly referred to as the kiddie tax. This generally applies to children under the age of 19. Also full-time students over the age of 18 and under the age of 24.
What is the Kiddie Tax?
The kiddie tax originated many years ago as a means to close a tax loophole. The loophole existed where parents would put their investments under their child’s name and social security number so that their investment income would be taxed at lower tax rates. Enter the kiddie tax, under which unearned income (investment income) more than a minimum amount is taxed at the parent’s highest marginal tax rate.
Greatest Tax Advantage and Tax Savings When Children Work? Tax-Free Income
On the bright side, a child’s earned income (income from working) is taxed at single rates. Currently the standard deduction for singles is $14,600 for 2024. This means that your child can make $14,600 from working and pay no income tax. (Note, they still will be subject to Social Security and Medicare payroll taxes). Also if the child contributes to a traditional IRA they can make $21,600 without paying income taxes. NOTE: the traditional IRA contribution cap is $7,000 in 2024.
And if you have the financial means, that same amount of an IRA contribution could be gifted to the child. This gives the child a great start toward their retirement savings. Not to mention a possible continuing incentive to save for their retirement.
Tax Advantages When Employing Your Child
If you are self-employed (an unincorporated business), a reasonable salary paid to your child reduces
- your self-employment (SE) income and
- your income tax by shifting income to the child.
For 2024, when a child under the age of 19 or a student under the age of 24 is claimed as a dependent of the parents, the child is generally subject to the kiddie tax rules if their investment income is upward of $2,600. Under these rules, the child’s investment income is taxed at the same rate as the parent’s top marginal rate. This is using a lower $1,300 standard deduction. However, earned income (income from working) is taxed at the child’s marginal rate. And the earned income is reduced by the lesser of the earned income plus $400 or the regular standard deduction for the year, which is $14,600. If a child has no other income, the child could be paid $14,600 and incur no income tax. If the child is paid more, the next $11,600 he or she earns is taxed at 10%.
Example Of Tax Savings When Children Work
Example: You are in the 22% tax bracket and own an unincorporated business. You hire your child (who has no investment income) and pay the child $16,500 for the year. You reduce your income by $16,500, which saves you $3,630 of income tax (22% of $16,500), and your child has a taxable income of $1,900 ($16,500 less the $14,600 standard deduction) on which the tax is $190 (10% of $1,900). The net income tax saved by the family is $3,440 ($3,630 – $190).
If the business is unincorporated and the wages are paid to a child under age 18, he or she will not be subject to FICA taxes. That is because employment for FICA tax purposes doesn’t include services performed by a child under the age of 18 while employed by a parent. Thus, the child will not be required to pay the employee’s share of the FICA taxes. In addition, the business won’t have to pay its half either. (FICA taxes include Social Security and Hospital Insurance – HI, aka Medicare). Finally, paying the child reduces the business’s net income. Which in turn reduces the parent’s self-employment tax payable on net self-employment income.
Second Example Of Tax Advantages When Employing Your Child
Example: Using the same circumstances as the example from above, and assuming your business profits are $180,000, by paying your child $16,500, you not only reduce your self-employment income for income tax purposes, but you also reduce your self-employment tax (HI portion) by $442 (2.9% of $16,500 times the SE factor of 92.35%). But if your net profits for the year were less than the maximum SE income ($168,600 for 2024) that is subject to Social Security tax, then the savings would include the 12.4% Social Security portion, $1,889 (12.4% of $16,500 x 92.35%), in addition to the 2.9% HI portion for a total savings of $2,331 ($442 + $1,889).
A similar but more liberal exemption applies for FUTA. (FUTA is the Federal Unemployment Tax Act.) Which is that it exempts federal unemployment tax from the earnings paid to a child under age 21 while employed by their parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting solely of the child’s parents. However, the exemptions do not apply to businesses that are incorporated. Nor a partnership that includes non-parent partners. Even so, there’s no extra cost to your business if you’re paying a child for work that you would pay someone else to do anyway.
Retirement Plan Savings
Additional savings are possible if the child is paid more and deposits the extra earnings into a traditional IRA. For 2024, the child can make a tax-deductible contribution of up to $7,000 to his or her own IRA. The business also may be able to provide the child with retirement plan benefits, depending on the type of plan it uses and its terms, the child’s age, and the number of hours worked. By combining the standard deduction of $14,600 and the maximum deductible IRA contribution of $7,000 for 2024, a child could earn $21,600 of wages and pay no income tax.
However, referring back to our original example: the child’s tax to be saved by making a $7,000 traditional IRA contribution is only $190. So it might be appropriate to make a Roth IRA contribution instead. This is since the child has so many years before retirement. Not to mention the future tax-free retirement benefits will far outweigh the current $190 savings.
Questions about the information provided here? For more information about possible tax benefits or issues related to hiring your child, please give this office a call.
Purr-Fect Savings: The Secrets Of Pet Tax Deductions
