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Children and Tax Advantages

I have several posts that relate hiring your children if you are self-employed or run you own side business. Well, there are other advantages, as well. Obviously, there is the dependent deduction, which is $3300 in 2006. Additionally, there is the Additional Child Tax Credit, which is $1000 per child in 2006 (http://www.irs.gov/newsroom/article/0,,id=106182,00.html). However, there are greater tax breaks available.




In previous posts, I discussed the ability that tax payers have if they hire their own children, if they are self-employed, or even have their own side business. Typically, when you hire employees, there are all sorts of taxes that must be paid. For instance, you may pay the Federal Unemployment Tax Act (FUTA) tax. In addition, employees must pay the Federal Insurance Contributions Act (FICA) tax, and employers must match that. However, when you hire your own children (in a sole-proprietorship or partnership with your spouse), you do not have to pay FUTA taxes on your children (if they are under the age of 21), and you child does not have to pay FICA taxes (if they are under the age of 18), and you do not have to pay the match. Any money that you pay to your children is a business expense, so it lowers your income amount, resulting in lowers tax. In addition, your child does not even have to have income taxes withheld if he/she earns less than the standard deduction. In 2006, the standard deduction for single individual is $5150. The only caveat is that your child must be at least eight years old, and you must follow child labor law practices (which means limiting the number of hours your child works). So, you can essentially have another $5150 tax break for each working child. That money stays in your family, and you can setup custodian accounts to direct the money in the way that you see fit, for your child.


So, do you do with that money? Many of us are looking for ways to fund our children’s education. I see two places where you can gain an even greater advantage from this situation. The Coverdell ESA (previously known as the Education IRA) and the Roth IRA are great places to store education funds. These accounts allow you to contribute after-tax funds, and the earnings are tax-free for qualified education expenses. However, in our situation, the contributions will be tax free, as well. I would suggest contributing to the Roth IRA first, for several reasons. For starters, all funds in a Coverdell ESA must be withdrawn, or transferred to another family member, by the age of 30, else there are penalties. Also, funds in a Coverdell ESA are considered in financial aid filing. The advantages of the Roth IRA are numerous. First, all contributions can be withdrawn after five years, without penalty. This is great if your child turns out to be a genius and gets a full scholarship, because your child could withdrawal these funds for a down payment on a home. Further, there is no age distribution on the Roth IRA, for education or retirement. Further, you may have not known that funds from a Roth IRA (contributions and earnings) can be used for qualified education expenses, penalty free. So, contribute the funds to a Roth IRA first ($4000 in 2006), then the remainder to a Coverdell ESA ($2000 in 2006). Plus, anyone can contribute to a Coverdell ESA, so a grandparent or relative could be nice and finish out the contribution to the Coverdell ESA, which would be $850, if the child earned right up to the standard deduction. Then, when your child withdrawals funds for education, withdrawal from the Coverdell ESA, first, and only touch the Roth IRA if absolutely necessary.


However, that is not all. There are other tax breaks available for children who are under eight, or are not employed by their parents’ business. Each child can have up to $800 per of unearned income that is tax free. This would include income from interest and dividends. So, at birth, you could gift an amount to your child that could produce $800 a year in interest. This would be in a custodial account. Then, you could withdrawal that $800, as you would not want to exceed that limit the following year, and you can either contribute it to a Coverdell ESA for your child, or you can use it to pay for non-essential expenses of your child (essential expenses include things that are the parents’ responsibility, like food and shelter). So, you could use the $800 per year for Christmas and birthday presents, entertainment expenses like movies or other things. I like the idea of jump starting a Coverdell ESA. Remember, a Roth IRA can only include contributions from earned income, and since your child cannot work until age eight, that means no Roth IRA until eight years of age.


These are ideas that I have considered for my children. Since my children’s education is of a great concern, I really look for ways that I can meet those needs. If I had to consider all of that as personal income, I would have to pay more in taxes, which might lower the amount that I can contribute. With three children, this adds up to a great amount. My oldest reaches the magical age of eight next month. And now, I am armed with some new tools to begin earlier with my younger two children.



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