Hiring Your Child To Work At Your Business This Summer

With school out, you might be hiring your child to work at your company. In addition to giving your son or daughter some business knowledge, you and your child could reap some tax advantages.

Benefits for your child

There are special tax breaks for hiring your offspring if you operate your business as one of the following:

•    A sole proprietorship,

•    A partnership owned by both spouses,

•    A single-member 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 an owner’s under-age-18 children as 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 (until an employee-child reaches age 21).

In addition, your dependent employee-child’s standard deduction can shelter from federal income tax up to $14,600 of 2024 wages from your business.

Benefits for your business

When hiring 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.

Note: There are different rules for corporations. If you operate as a C or S corporation, your child’s wages are subject to Social Security, Medicare and FUTA taxes, like any other employee’s. However, you can deduct your child’s wages as a business expense on your corporation’s tax return, and your child can shelter the wages from federal income tax with the $14,600 standard deduction for single filers.

Traditional and Roth IRAs

No matter what type of business you operate, your child can contribute to an IRA or Roth IRA. With a Roth IRA, contributions are made with after-tax dollars. So, taxes are paid on the front end. After age 59½, the contributions and earnings that have accumulated in the account can be withdrawn free from federal income tax if the account has been open for more than five years.

In contrast, contributions to a traditional IRA are deductible, subject to income limits. So, unlike Roth contributions, deductible contributions to a traditional IRA 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 IRA for several reasons. Notably, your child probably won’t get any meaningful write-offs from contributing to a traditional IRA because the child’s standard deduction will shelter up to $14,600 of 2024 earned income. Any additional income will likely be taxed at very low rates.

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. Of course, even though your child can withdraw Roth contributions without adverse tax consequences, the best strategy is to leave as much of the Roth balance as possible untouched until retirement to accumulate a larger 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 to an IRA or Roth IRA the lesser of:

•    His or her earned income, or

•    $7,000.

Making modest Roth contributions can add up over time. For example, suppose your child contributes $1,000 to a Roth IRA each year for four years. The Roth account would be worth about $32,000 in 45 years when he or she is ready to retire, assuming a 5% annual rate of return. If you assume an 8% return, the account would be worth more than three times that amount.

Caveats

Despite what you pay in, you might receive more in Social Security benefits than you pay into the system. An Urban Institute report looked at some average situations. For example, a single man who earned average wages every year of his adult life and retired at age 65 in 2020 would have paid about $466,000 in Social Security and Medicare taxes. But he can expect to receive about $640,000 in benefits during retirement. Of course, there are many factors involved and each situation is unique. Plus, these calculations don’t account for the interest the Social Security tax dollars would have earned over the years.

Some people think the government has set up an account with their name on it to hold money to pay their future Social Security benefits. After all, that must be where those Social Security taxes on wages and self-employment income go. Sorry, but this is incorrect. There are no individual accounts — just a promise from the government.

Is the Social Security system financially solid? It’s on shaky ground. Congress has known that for years and has done nothing about it (although there have been many proposals on how to fix things). A Social Security Administration report states that “benefits are now expected to be payable in full on a timely basis until 2037, when the trust fund reserves are projected to become exhausted. At the point where the reserves are used up, continuing taxes are expected to be enough to pay 76% of scheduled benefits.”

The agency adds that “Congress will need to make changes to the scheduled benefits and revenue sources for the program in the future.” These changes could include a higher age to receive full benefits, additional Social Security tax hikes in the form of higher rates, some tax-law revision that effectively implements higher ceilings or a combination of these.

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