If you own a small business, you might consider hiring your kids to work during their time off from school. In addition to teaching your children some financial responsibility and business sense, there are some tax advantages to factor into your decision. Here are the details.
Tax Advantages for Your Child
There are special tax breaks for hiring your offspring if you operate your business as one of the following types of entities:
- A sole proprietorship,
- A partnership owned by both spouses,
- A single-member limited liability company (LLC) that’s treated as a sole proprietorship for tax purposes, or
- An LLC that’s treated as a partnership owned by both spouses.
These entities can hire the owner’s (or owners’) under-age-18 children as legitimate full- or part-time employees. The children’s wages then will be exempt from the following federal payroll taxes:
- Social Security tax,
- Medicare tax, and
- Federal unemployment (FUTA) tax.
The FUTA tax exemption lasts until an employee-child reaches age 21.
In addition, your dependent employee-child’s standard deduction can shelter up to $14,600 of 2024 wages received from your business from federal income tax. That means your child will owe no federal taxes on the first $14,600 of 2024 wages, unless he or she has income from other sources. The child can set up a savings account for some or all of the wages, as well as contribute to an IRA, Roth IRA or college fund.
Tax Advantages for Your Business
When you hire your child, you get a business tax deduction for employee wage expense. The deduction reduces your federal income tax bill, your self-employment tax bill and your state income tax bill, if applicable.
Important: There are different rules for corporations. Unfortunately, if you operate your business as a C or S corporation, your child’s wages will be subject to Social Security, Medicare and FUTA taxes, like any other employee. However, the following tax breaks are still available:
- You can deduct your child’s wages as a business expense on your corporation’s tax return,
- Your child can shelter the wages from federal income tax with the standard deduction, which is $14,600 for 2024, and
- Your child can set aside some of the wages in an IRA, Roth IRA or college fund.
Roth IRA Angles
With Roth IRAs, the annual contributions are made with after-tax dollars. So, taxes are paid on the front end. Then the contributions and earnings that have accumulated in the account can be withdrawn federal-income-tax-free after age 59½ if the account has been open for more than five years.
Roth IRAs are a smart retirement saving tool, especially for young people. Why? First, most kids are currently in comparatively low tax brackets, so being unable to deduct the annual contributions is no big deal. Second, they probably won’t retire for decades, which gives ample time for the account to grow in value, tax free. In addition, your child can withdraw all or part of the annual Roth contributions — without any federal income tax or penalty — to pay for college or for any other reason.
Important: Even though your child can withdraw Roth contributions without any adverse federal income tax consequences, the best strategy is to leave as much of the Roth account balance as possible untouched until retirement age to accumulate a larger federal-income-tax-free sum.
The only tax-law requirement for your child when making an annual Roth IRA contribution is having earned income for the year that at least equals what’s contributed for that year. There’s no age restriction. For the 2024 tax year, your child can contribute the lesser of:
- His or her earned income, or
- $7,000.
The $7,000 contribution limit applies to both Roth IRAs and traditional IRAs.
Making modest Roth contributions as a young adult can add up over time. For example, suppose your child contributes $1,000 to a Roth IRA at the end of each year for four years. The Roth account would be worth about $33,000 in 45 years when he or she is ready to retire, assuming a 5% annual rate of return. If you assume a more-optimistic 8% return, the account would be worth about $114,000 in 45 years. (Double those amounts, if you can convince your child to contribute $2,000 at the end of each of the four years.)
Traditional IRAs
Traditional IRAs are another retirement saving option to consider. Contributions to a traditional IRA are deductible, subject to income limits. So, unlike Roth contributions, deductible contributions to traditional IRAs lower the employee-child’s taxable income.
However, contributing to a Roth IRA is usually a much better idea for a young person than contributing to a traditional deductible IRA for several reasons. Notably, your child probably won’t get any meaningful write-offs from contributing to a traditional IRA, because an unmarried dependent child’s standard deduction will automatically shelter up to $14,600 of 2024 earned income from federal income tax. Any additional income will almost certainly be taxed at very low rates.
Plus, traditional IRAs are taxed at the back end. If your child makes deductible contributions to a traditional IRA, any subsequent withdrawals must be included in gross income — and your child will likely be in a higher tax rate during retirement than he or she currently is. Even worse, traditional IRA withdrawals taken before age 59½ will be hit with a 10% early withdrawal penalty tax unless an exception applies. (Two exceptions are to pay for qualified higher-education expenses and to withdraw up to $10,000 for eligible first-time homebuyers.)
So, unless the child has enough income to owe a significant amount of tax, the theoretical advantage of being able to deduct traditional IRA contributions is mostly or entirely worthless to your child. Because that’s the only advantage a traditional IRA has over a Roth account, the Roth option usually makes the most sense for young adults.
For More Information
Hiring your child can be a tax-smart idea. However, your child’s wages must be reasonable for the work performed. So, the hire-your-kid strategy works best with teenagers or college students who can be assigned meaningful duties.
You’ll need to maintain the same records as you would for any other employee to substantiate the hours worked and duties performed. This includes timesheets, job descriptions and W-2 forms. Contact your tax advisor with any questions you have about employing your kids to work for your small business.
@2024