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Saving for Retirement: The Younger the Better

Yesterday, in the post entitled Kids and Money, I discussed the tax advantages of hiring your children. Today, I went in search of more tangible information regarding this insight. The Boston Globe has an article entitled The Tax Benefits of Hiring Your Children.

The article outlines some specific criteria for hiring your children and discusses under what circumstances you can avoid FICA and FUTA taxes. Also, it exposes the limits to the tax free money your children can earn, and sheds a very understable reason for this.

So, how can you pay your children money and avoid payroll taxes? Well, if you employ them via a good legal entity (Corporate, LLC, LP, etc), then you are out of luck. Further, if your business is a unicorporated partnership, the partnership must be 100% owned by the children's parents. If you avoid these situations, congratulations, you do not have to pay Social Security, Medicare, or Unemployment taxes to hire your child! If you do fall into one of these categories, however, there may still be hope. As with any risky business, I would always recommend that you use good legal entities to structure your business. But, how can you do this and still bypass FICA and FUTA? You can personally run a sole-proprietorship that provides services to your legal entity. This is still pretty safe, if you only provide services for your entities, and do not solicit business elsewhere. For instance, your sole-proprietorship could provide staffing for your entities. Your children would be an employee of your sole-proprietorship staffing agency, and they would perform work for your legal entity. The entity would pay your sole-proprietorship, and you would pay your child from your sole-proprietorship.

So, now that you have established that you can find a way to hire your children and receive great tax savings, you must determine their pay. First, and foremost, the IRS has stated that you must pay a reasonable amount to your children to perform the work. What would you pay an outsider to perform the tasks? You better be in the right ballpark. Further, you had better abide by child employment restrictions. For instance, they must not work beyond the limit for their age and whatever hourly restrictions are in place when school is in session.

Now that you can hire them, and you understand your obligations, how much can you pay them without having to fork over income tax? We look to the standard deduction for this. Simple, eh? In 2005, the standard deduction was $5000. And since it is adjusted for inflation, this amount will continue to rise. For 2006, the standard deduction for an individual is $5150. So, if your child earns less than this, and does not exceed $250 in unearned income (dividends and interest), then your child has no tax liability. And, if your child contributes to a Traditional IRA, then that amount increases by up to $4000 per year, through 2007, and $5000 a year beginning in 2008.

So, how do you pay your child? For purposes of legitimacy, regularly. If you pay hourly employees bi-weekly, then pay your child bi-weekly. If you only employ your children, then setup an appropriate schedule for payments. Some states have various guidelines, such as a minimum of semi-monthly. If the IRS notices a lump sum payment at the end of the year, this could signal that you are avoiding taxes, which is legal, but the IRS may want to get into your business.

So, where should your children's money go. Remember, you are a parent and you are not subject to your child's will. However, give them a little freedom, and teach them well so that they can make good decisions on their own. If college is in your child's future, a Coverdell ESA is a good place to stick some money. This is an IRA-style account that mimicks a Roth. You use after tax funds to seed the account, which means nothing since your child's tax liability is zero, and withdrawals are tax if used for qualified educational expenses. These can be for college, or even earlier. The limit in 2006 for a Coverdell ESA is $2000 per beneficiary. Beyond that, a Roth IRA is a very good place to sock away funds. Getting your child in the habit of retirement investment is very good, and the earlier savings are started, the longer compounding has to work its magic. Further, contributions can be withdrawn for any purpose, however earnings must remain until age 59 1/2. This means your child could buy a home after college, all with funds that were never taxed.

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