On our “Kids And Why They Are Awesome for Tax Savings" Facebook Live session, I discuss tax planning strategies and some of the ways your kids can be a benefit for saving money during tax time.
Effects of Tax Savings Over Time
Let’s take a look at how structuring your finances for tax efficiencies can completely change the way you grow your wealth for the future. In the below chart you can see the impact that taxes have on compounded interest over time.
If you were to double a single dollar over 20 years, look what happens when we cut out the taxes on those earnings. As you can see, even reducing your tax rate 10% down to 25%, has a huge impact on your ability to grow your wealth – $800,000 versus just $22,000.
If there’s just one thing I want you to take away from this presentation today, that is, if you forget everything else I say, I want you to remember this: you lose every time you spend after tax dollars that could have been pre-tax dollars.
Now that you have a great understanding of why tax planning is essential to building your wealth, we will look at some of the ways your kids can be used to save money!
Tax Reform Change: Child Tax Credit
We are first going to talk about the Child Tax Credit. I want to discuss the difference between a credit and a deduction.
A deduction lowers your taxable income then the tax is calculated off of that income. Deductions are not dollar for dollar.
However, credits lower your tax liability so they are a dollar for dollar reduction and much more valuable. In 2018, due to tax reform, the child tax credit s worth up to $2,000 per qualifying child. The age cut-off remains at 17 years old as of 12/31. $1,400 of the credit is refundable, meaning you could receive some of the credit even if you don’t have any tax liability.
Another great tax reform change is the income phaseout increased from $110K to $400K for joint filers and $55K to $200K for singles. That’s a huge jump and opportunity for more individuals, like myself, to take advantage of all those kids!
Tax Reform Change: Kiddie Tax
Let’s talk about if your child has unearned income. If you open an UGMA/UTMA account for them to invest the money they earn or you just gift them money up to the annual exclusion, which is $15,000 in 2018, the investment income they earn through that account is subject to the “kiddie tax” rules.
In 2017 those rules say that if your child earns more than $2,100 in investment income, anything above that amount is taxed at your rate, not theirs. Those rules apply until your child hits age 19, or age 24 if they’re a fulltime student and you claim them as a dependent.
The new law keeps the same concept of special rates on your child’s unearned income. But instead of paying tax at your rate, now they’ll pay tax at special rates that apply to trusts and estates. Why is that so bad? Well, just take a look at the rates! They Iook easier because there are just four of them. But wow, they are a steep climb. They start at the same 10% as for everyone else. But they jump to 24% after just $2,550 of income, then 35% after just $9,150, and finally to the top 37% rate after just $12,500. This came as an under-the-radar change for a lot of people!
Tax Saving Strategies
Let’s talk about some tax strategies that weren’t impacted negatively with tax reform.
Income Shifting to your Children: Earned Income
How many of you have your child working in your business?
What age do you think is “IRS approved” for your kids to work in your business? – answer… age 7 according to tax court rulings. Yes, I have seen taxpayers get away with making their infant a “working model” for their website or marketing materials but why poke the bear?
For most of us, our children don’t earn a lot of money, which puts them in a lower bracket. Let’s say you have $100,000 in the bank earning $1,000 in interest. If you’re in the 24% tax bracket, you’ll pay $240 in tax on that income. But if your child is in the 0% bracket, and you put the account in their name, they’ll pay nothing. Seems like an obvious opportunity, right?
If you’re a business owner, you can hire your children and deduct their pay. They can earn as much as $12,000 — the standard deduction for singles — in 2018 and pay absolutely no federal income tax. Also, they can earn an additional $5,500 without paying current tax if they contribute it to a traditional IRA. You also get to take a 7 business deduction for their salary and, depending on your business type, you can also avoid payroll taxes.
You do not have to pay payroll taxes for employing your kids if your business is a sole-proprietorship, a single-member LLC (SMLLC) taxed as a disregarded entity, or an LLC taxed as a partnership and owned solely by you and your spouse. However, even if you have a corporation (C-corp or S-corp), you can still avoid paying payroll taxes on your child’s salary by creating a family management company to support the operations of your corporation and structure it was an SMLLC or sole proprietorship.
Keep in mind, though, your kids can’t just be hanging out in your office. They must perform actual work and be paid in line with what you’d pay non-family employees. You will also want to document the work they are providing you.
Income Shifting to your Children: Gift Leaseback
If your children are too young or too busy to work in your business, you can use the “Gift Leaseback” strategy. This strategy basically involves you gifting your children the equipment in your business and having your child lease the equipment back to your business. Ultimately, your business receives a deduction for the lease payments and your child earns income they can use towards their standard deduction and retirement contributions. Of course, you have to make sure everything is documented properly to avoid IRS scrutiny.
Make your child a tax-free millionaire
Here’s a great bonus too, that most people aren’t talking about. When you hire your kids to work in your business, you are qualifying them to make contributions to a ROTH IRA. Now you know the ROTH earns tax free income right? So let's say you contribute just $5,500 per year starting at age 7 and only up until age 17 for your child and an annual growth rate of 8% (yes, I know it is a bit high rate of return in today’s market but it’s just for example purposes). By the time your kid reaches retirement age of 65, they’ll have over $2 million dollars tax free in their account. While you’ve only put in $55,000 that saved you on taxes.
Take it a step further...If your child chooses not to tap this money during retirement but left it to their children, assuming death at age 95 and 8% growth rate, your grandchildren would inherit over a whopping $22 million! All of this because you chose to encourage them to work, save and invest. Now that's what I call a great legacy!
Have you thought about employing your child or are you already? I'd love to know how it's gone for you! Drop me a line and let me know!