Summer jobs can be an effective way to teach children about financial responsibility, encourage them to save for college or retirement, and provide them with spending money during the school year. If you own a business, consider hiring your child (or grandchild) as a legitimate employee. It can be a smart tax-saving strategy for employee and employer alike, especially under the Tax Cuts and Jobs Act.
When you hire your child, you get a business tax deduction for employee wage expenses. In turn, the deduction reduces your federal income tax bill, your self-employment tax bill (if applicable), and your state income tax bill (if applicable).
Your child's wages are also exempt from Social Security, Medicare, and FUTA taxes, if the following conditions are met:
- Your business operates as a sole proprietorship, a single-member limited liability company (LLC) that's treated as a sole proprietorship for tax purposes, a husband-wife partnership or an LLC that is treated as a husband-wife partnership.
- Your child is under age 18 (or under age 21 in the case of the FUTA tax exemption).
- Your child is a legitimate part-time or full-time employee of the business.
Unfortunately, S and C corporations aren't eligible for this break. For corporations, your child's wages will be subject to Social Security, Medicare and FUTA taxes just like they would be for any other employee. But tax breaks are still available. You can deduct your child's wages as a business expense on your corporation's tax return.
Thanks to the TCJA, your employee-child can use his or her standard deduction to shelter up to $12,000 of 2018 wages paid by your business from the federal income tax. For 2017, the standard deduction was only $6,350. But the TCJA nearly doubled it for 2018 through 2025. That makes the hiring-your-kid strategy better than before.
Important note: For an unmarried dependent child with earned income, the 2018 standard deduction is the greater of 1) $1,050 or 2) earned income + $350 but no more than $12,000.
In other words, for 2018, your child will owe nothing in federal taxes on the first $12,000 of wages, unless he or she has income from other sources. Your child can save some of the wages — and possibly even contribute money to a Roth IRA or put it into a college fund.
The Roth Angle
The only tax-law requirement for your child to make annual Roth IRA contributions is having earned income for the year that at least equals what's contributed for that year. Age is completely irrelevant. So, if your child earns some cash from a summer job or part-time work after school, he or she is entitled to make a Roth contribution for that year.
For the 2018 tax year, a working child can contribute the lesser of:
- His or her earned income, or
While the same $5,500 contribution limit applies equally to Roth IRAs and traditional deductible IRAs, the Roth option usually makes more sense for young people. Why? 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. However, Roth earnings generally can't be withdrawn tax-free before age 59½.
In contrast, if your child makes deductible contributions to a traditional IRA, any subsequent withdrawals must be included in gross income. Even worse, traditional IRA withdrawals taken before age 59½ will be hit with a 10% early withdrawal penalty tax unless an exception applies. (One exception is to pay for qualified higher-education expenses.)
Important note: 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 (or later) in order to accumulate a larger federal-income-tax-free sum.
Modest Contributions Can Add Up
By making Roth contributions for just a few teenage years, your child can potentially accumulate a significant nest egg by retirement age. Realistically, however, most kids won't be willing to contribute the $5,500 annual maximum even when they have enough earnings to do so.
If you can talk your teenager into contributing a meaningful amount toward retirement — rather than buying clothes at the mall, concert tickets or V-Bucks to spend on Fortnite (the latest video game fad) — here's what could happen.
Tommy the Teenager contributes $1,000 to a Roth IRA at the end of each year for four years (ages 15 through 18). Assuming a 5% annual rate of return, the Roth account would be worth about $33,000 in 45 years when the "kid" is 60 years old. If you assume a more-optimistic 8% return, the account would be worth about $114,000 in 45 years.
If Tommy's parent could talk him into contributing $2,500 each year, his Roth account would be worth a whopping $285,000, assuming an 8% rate of return.
Tax Deductions for Traditional IRA Contributions
Aren't the tax deductions for traditional IRA contributions an advantage compared to contributing to Roth IRAs? While it's true that there are no write-offs for Roth contributions, your child probably won't get any meaningful tax breaks from contributing to a traditional IRA either. That's because an unmarried dependent child's standard deduction will automatically shelter up to $12,000 of 2018 earned income from federal income tax. Plus, any additional income will almost certainly be taxed at very low rates.
So, unless the child has enough taxable income to owe a significant amount of tax, the theoretical advantage of being able to deduct traditional IRA contributions is mostly or entirely worthless. Since that's the only advantage a traditional IRA has over a Roth account, the Roth option almost always comes out on top.
Tax-Savvy Parents Raise Tax-Savvy Kids
Hiring your child can be a tax-smart idea. Remember, however, that the child's wages must be reasonable for the work performed. So, this strategy works best with teenage children whom you can assign meaningful tasks to. Keep the same records as for any other employee to substantiate hours worked and duties performed (such as timesheets and job descriptions), and issue your child a Form W-2, as you would for any other employee.
Encouraging your child to make Roth IRA contributions is a great way to introduce the ideas of saving money and investing for the future. It's also a great lesson in tax planning. It's never too soon for children to learn about taxes and how to legally minimize or avoid them.