Article Highlights
- Standard Deduction
- IRA Options
- Self-Employed Parent
- Employing Your Child
- Tax Benefits
What is often known as the "kiddie tax" applies to children who are dependents of their parents. Children under the age of 19 and full-time students beyond the age of 18 but under the age of 24 are often covered by this.
The kiddie tax was created many years ago to shut a tax break that allowed parents to invest under their child's name and social security number, resulting in reduced tax rates on the investment income. This brings us to the kiddie tax: any unearned income (investment income) that exceeds a certain threshold is subject to taxation at the parent's highest marginal tax rate.
Tax-Free Income - Positively, a child's earned income—that is, income from employment—is subject to single-rate taxation, with a $14,600 standard deduction for individuals in 2024. This means that if your child is willing to contribute to a traditional IRA, the maximum contribution for which is $7,000 in 2024, they can make $21,600 from working without paying any federal income tax. Alternatively, they can earn $14,600 from working and pay no income tax (though they will be subject to Social Security and Medicare payroll taxes).
If you, a grandparent, or others have the money, you could gift your child the amount of an IRA contribution, even if they are hesitant to give up any of their hard-earned money from their summer or regular employment. This will give them a head start on their retirement savings and hopefully provide ongoing motivation to save for their future.
Employing Your Child - Paying your child a fair wage lowers both your income tax and your self-employment (SE) income if you own an unincorporated firm and are self-employed.
In 2024, if a student under 24 or a child under 19 is declared as a dependant of their parents and their investment income exceeds $2,600, the youngster will usually be subject to the kiddie tax regulations. According to these regulations, the child's investment income is subject to a smaller $1,300 standard deduction and is taxed at the parent's top marginal rate. Earned income, on the other hand, is taxed at the child's marginal rate and is subject to a reduction equal to the lesser of the earned income plus $400 or the $14,600 normal standard deduction for the year. A youngster might receive $14,600 and not have to work if they don't have any other sources of income.
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).
Since employment for FICA tax purposes does not include services performed by a child under the age of 18 while employed by a parent, if the business is unincorporated and wages are paid to a child under the age of 18, that child will not be subject to FICA - Social Security and Hospital Insurance (HI, aka Medicare) - taxes. As a result, neither the business nor the kid will be obliged to pay their respective portions of the FICA taxes. Additionally, the parent's self-employment tax liability on net self-employment income is decreased by paying the kid and therefore lowering the net income of the firm.
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).
FUTA, which exempts from federal unemployment tax wages provided to a kid under age 21 while working by their parent, has a comparable but more generous exemption. Additionally, if a kid works for a partnership that is made up entirely of the child's parents, the FICA and FUTA exemptions also apply. Nevertheless, incorporated companies and partnerships with non-parent participants are not covered by the exclusions. Nevertheless, paying a youngster to complete tasks that you would otherwise hire an outside party to complete doesn't incur any additional costs for your company.
Retirement Plan Savings - If the child is paid more and puts the extra money into a regular IRA, they may be able to save even more. The youngster is eligible to contribute up to $7,000 (tax deductible) in 2024 to his or her own IRA. Retirement plan benefits may also be available to the kid from the business, contingent on the child's age, the kind and conditions of the plan, and the amount of hours worked. A kid might make $21,600 in salary and pay no income tax by combining the standard deduction of $14,600 with the maximum deductible IRA contribution of $7,000 for 2024.
But going back to our original example, the child would only save $190 in taxes by contributing $7,000 to a traditional IRA. Given that the child has a long way to go before retiring and that the future tax-free benefits will greatly exceed the $190 in savings, it might be more appropriate to contribute to a Roth IRA instead.
Please contact our office with any questions you may have regarding the information presented here, additional potential tax benefits, or matters with employing your kid.
