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It’s tough to run a small business, even if it’s “just” a side hustle. It’s even tougher if you have kids. But it doesn’t have to be. It doesn’t have to act as a
drain on your time and energy. Rather, it can offer a benefit that can both save money and increase the family net worth. All it takes is getting your kids to help you out. Oh, and paying them for their work.
“Pay my kids? They need to learn to be responsible and that means working for the family business out of a sense of obligation, not to make money!” no doubt some are shouting.
Maybe. But what bigger responsibility can be gained than learning to make and live within your own budget, control your spending and save for the future. These are some of the advantages of putting your child on the payroll.
But that’s only the tip of the iceberg. Parents should consider how they would answer this question: “Would you be willing to reduce today’s taxes if it meant making your children tax-free multimillionaires when they retire?” If you find yourself so willing, then pay your kids as you would any other employee.
Parent-owned businesses—including those increasingly popular side hustles—that have discovered this often overlooked synergy between work and family can find that it offers quite a few financial benefits. Marguerita Cheng, Chief Executive Officer at Blue Ocean Global Wealth in Gaithersburg, Maryland, says, “It can provide tax savings and the ability for the employee owner to build wealth outside of the business.”
Now, before moving along any further, it’s important to note there are rules regarding the employment of minor children. There are federal child labor laws and there are state child labor laws. The rules may or may not exempt parents who hire their children. In nearly all cases, however, a child cannot perform dangerous work or work in dangerous environments.
In general, federal labor law permits minor children to work for their family business. Again, it’s important to emphasize there may be local laws that supersede the federal law. Still, even when the state law may seem to prohibit parents from employing their younger children, exemptions may exist. For example, New York State Child Labor Law prohibits parents from hiring their kids who aren’t yet 14 years old. The State does provide for some limited exemptions. It will allow you to hire your 12-year-old under certain restrictive circumstances. Furthermore, you can hire your newborn baby as a model as long as that infant is more than 15 days old. If you have any questions about your eligibility, you’ll need to contact a competent child labor attorney who is familiar with the applicable laws in your jurisdiction.
Here’s one place where you can save money: depending on how your business is organized, the IRS rules may exempt your child from payroll taxes. This works especially well for side hustles, which are often organized as a sole proprietorship.
The tax savings don’t stop there. The new tax law immediately grants a standard deduction of $12,000. If you pay your child $12,000, and you operate a sole proprietorship, the child pays no payroll taxes and no federal income tax (of course, the states have their own rules regarding their own taxes).
Let’s review this. By hiring your child, you can essentially transfer wealth to the next generation virtually tax-free and without any annual gift allowance ramifications. In addition, this is accomplished in a way that can lower your family’s current tax liability. Yes, this means your side hustle will generate less net income. Are you still willing to pay that price to save money on taxes today?
That gets us to the second half of our question. This is the part about your child retiring as a tax-free multimillionaire. Despite a child paying practically nothing in taxes on the wages earned from a parent’s business, those wages still count as earned income. That means the child is eligible to start a Child IRA.
A Child IRA is just like an Individual Retirement Account for an adult. You have the choice to fund a Traditional IRA with pre-tax money. In doing so, you take a taxable deduction now but pay taxes on the money you withdraw from the IRA when you retire. Alternatively, you can put your after-tax money into a Roth IRA and withdraw it tax-free when you retire. Since the child pays no or very little tax, it tends to make more sense to establish and contribute to the Roth version of a Child IRA.
Here are several different scenarios to give you a sense of what’s practical. Although it’s possible for a newborn baby to start a Child IRA, to keep it simple these hypothetical situations will apply just to older kids. This best represents the circumstances many Millennials (and quite a few Gen-Xers) who have a side hustle find themselves in today. After reading these illustrations, consult with your tax advisor to determine how you can best implement this strategy.
As a base-case, consider first the example where the parent hires a 13-year-old child who earns enough to save the maximum amount into a Child IRA ($6,000 in 2019). It’s not unusual for minors to earn $6,000 over the course of a year. While work time may be limited during the school year, the summer will more than make up for it.
This annual $6,000 contribution into the Child IRA continues through age 18 when the child goes off to college. Let’s assume the child stops working at this point and no longer contributes to the IRA. Furthermore, let’s say the investments over the next 50+ years grow at a rate of 8% per year (that’s about 3% less than the historic return rate). When that child retires at age 70 (because that’s likely to be the minimum age today’s children will retire at), those paltry six years (ages 13-18) of $6,000 annual contributions will have grown to a figure of about $2.5 million.
Remember, that doesn’t include the retirement savings the child amasses as an adult. The Child IRA certainly gives the child a leg up on retirement. And what parent doesn’t want to give their kid an edge when it comes to retirement saving? “Parents may sleep better at night knowing their child has a head start on saving for retirement, and with investing’s most valuable asset on their side, time,” says Madison Parker of Parker Financial Group in Overland Park, Kansas. “This head start will most likely better position a child for a secure retirement, regardless of the status of Social Security in the future.”
What happens if the child doesn’t establish a Child IRA at age 13? What happens to that poor child who lives in New York State and can’t start working until age 14? It’s only a year later—one year less to earn (and save in a Child IRA) that $6,000 before going to college. What difference does it make to miss one $6,000 annual Child IRA contribution?
It turns out there’s a pretty sizable difference. By missing that one single year of contributing the maximum amount to a Child IRA at age 13, the child loses a half million dollars when retiring at age 70. Wow! This’ll drive even more folks to move out of the Empire State!
OK, perhaps it would be nice to cut this once most-populous state a break (it is, after all, one of the thirteen original colonies). Recall New York does allow some parents to hire their 12-year-old children. What does this extra year add? (Again, the child stops contributing at age 18 when starting college.) This additional year of contributing the maximum into a Child IRA ups the value of that savings tool at age 70 another half million dollars to nearly $3 million.
And since it’s likely that Child IRA will be the Roth version, that $3 million can be withdrawn tax-free in retirement.
Now, let’s ask our original question one more time: “Would you be willing to reduce today’s taxes if it meant making your children tax-free multimillionaires when they retire?”
Your kids are anxiously awaiting your response.
April 2, 2019 at 06:14AM
Forbes – Entrepreneurs