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 and full-time students over the age of 18 and under the age of 24.
The kiddie tax originated many years ago as a means to close a tax loophole 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) in excess of a minimum amount was taxed at the parent’s highest marginal tax rate.
Tax reform enacted late in 2017 changed the way children are taxed by no longer having the children’s unearned income taxed at the parent’s top marginal tax rate, but instead at fiduciary income tax rates, which generally result in higher taxes on the unearned income.
Tax-Fee Income – On the bright side, a child’s earned income (income from working) is taxed at single rates, and tax reform just about doubled the standard deduction for singles. The standard deduction is $12,200 for 2019. This means that your child can make $12,200 from working and pay no income tax (but will be subject to Social Security and Medicare payroll taxes), and if the child is willing to contribute to a traditional IRA, for which the 2019 contribution cap is $6,000, the child can make $18,200 from working—federal income tax free.
IRA Contributions – Even if your child is reluctant to give up any of their hard-earned money from their summer or regular employment, if you, a grandparent, or others have the financial resources, the amount of an IRA contribution could be gifted to the child, giving your child a great start toward their retirement savings and hopefully a continuing incentive to save for their retirement.
Roth IRAs are actually a better alternative; unlike Traditional IRAs, they provide tax free income at retirement. However, the contribution to a Roth is not deductible, and thus income in excess of $12,200 would not be tax free. Even so, the tax rate at the lower income level is only 10%, and it may be worth paying a small tax to gain the tax-free retirement provided by a Roth IRA.
Employing Your Child – If you are self-employed (an unincorporated business), rather than helping support your children with your post-tax dollars, you can instead hire them to work for your business and pay them with tax-deductible dollars. Of course, the employment must be legitimate and the pay commensurate with the hours and the job worked.
Wages paid to a child under age 18 are not be subject to FICA—Social Security and Hospital Insurance (HI, aka Medicare) taxes—since employment for FICA tax purposes doesn’t include services performed by a child under the age of 18 when employed by a parent. Thus, the child will not be required to pay the employee’s share of the FICA taxes, and the business won’t have to pay its half either. In addition, by paying the child and reducing the business’s net income, the parent’s self-employment tax that is payable on net self-employment income may also be reduced.
Example: Let’s say you are in the 24% tax bracket and own an unincorporated business. You hire your child (who has no investment income) and pay the child $15,000 for the year. You reduce your income by $15,000, which saves you $3,600 in income taxes (24% of $15,000), and your child has a taxable income of $2,800 ($15,000 less the $12,200 standard deduction) on which the tax is $280 (10% of $2,800). A $2,800 contribution to your child’s traditional IRA would bring the child’s taxable income down to zero, and the child would owe no federal income tax.
By paying your child $15,000, you not only reduce your self-employment income for income tax purposes but you reduce your self-employment tax (HI portion) by $402 (2.9% of $15,000 times the SE factor of 92.35%). However, if your net profits for the year were less than the maximum SE income ($132,900 for 2019) subject to Social Security tax, then the savings would include the 12.4% Social Security portion in addition to the 2.9% HI portion. In this case, the total SE tax savings would be $2,119.
A similar but more liberal exemption applies for FUTA, which exempts from federal unemployment tax the earnings paid to a child under age 21 while employed by his or her parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting solely of his or her parents. However, the exemptions do not apply to businesses that are incorporated or a partnership that includes non-parent partners. Even so, there’s no extra cost to your business if you’re paying your child for work that you would pay someone else to do anyway.
If you have questions related to your child’s employment or about hiring your child to work for your business, please call this office.