Hiring your child to work as a legitimate employee is a great tax strategy, which got even better with the Tax Cuts and Jobs Act. Starting in 2018, the standard deduction nearly doubled, from $6,350 to $12,000, meaning under the new law, your child can shelter almost twice the wage income without paying income taxes.
Benefits of paying wages to your child include: shifting income from your higher tax bracket to your child’s lower tax bracket, potentially saving self-employment and FICA tax on wages paid to your child, and allowing both you and your child to make Roth IRA contributions.
The IRS knows that there are tax benefits to hiring your child, so you’ll want to make sure you follow the rules so you don’t lose your tax deductions, and risk your child getting taxed on their benefits.
*Your child must be a real employee. Make sure they are being paid for work they actually performed, and that the work they are being paid for is necessary for your business. Also, you should make sure your child is an appropriate age to work; the IRS isn’t going to believe that your toddler is providing valuable administrative services to your company.
*Your child’s wages must be reasonable. Of course, you want to pay your child well, but you shouldn’t pay them more than you pay someone else to do the same job. You probably wouldn’t pay a stranger $200 an hour to answer phones at your office, so you shouldn’t inflate the hourly rate of your child to get a bigger tax deduction.
*You must comply with legal requirements, as you would for any other employee. Your child will need to fill out all legal forms required for employees (W-4, I-9, etc.), and get paid on a regular schedule like the rest of your staff. Keep track of the hours worked by your child with a timecard, and pay your child by check or direct deposit so you have record of how much you paid, and that you actually paid them. Make sure you issue a W-2 annually for wages paid.
With your child making some money, there is a great opportunity to save for their future and start contributing to their Roth IRA. Tax requirements allow your child to make annual Roth IRA contributions equal to their earned income for the year. By choosing a Roth IRA, your child can withdraw any part of the annual contribution without a federal income tax or penalty, which can for instance, be used for college. While the Roth IRA gives the flexibility to withdraw without federal income tax or penalty, the best approach to saving is to leave as much of the account balance untouched until retirement age since the growth is nontaxable when distributed.
Hiring your child can be a great idea. It’s tax smart for you, and it might help teach your child some added responsibility. Follow the rules, and reap the benefits!