How to Pay Your Children and Take Advantage of Early Savings Utilizing a Roth
“I run my own creative business and want to start paying my children a salary. Is this legal? What are the benefits and are there any restrictions I should know about?”
I’m Lauren, a financial planner who specializes in working with creative business owners. When I sit down with clients, we discuss financial decisions with their best interests in mind. Sometimes, this includes discussing how to make the most of a tax situation as well as setting children up for the future.
Thinking about your kids’ retirement might be a bit weird, but paying your kids a legitimate salary can have huge advantages for financially protecting their future. However, the advantages can be extended to your own tax situation and the profits of your business, too. Let’s get into it.
Children’s Salaries
There are a few things to note before you decide to start paying your kids a salary. Firstly, it’s a completely legal and legitimate thing to do, and there is no lower limit on the age of your child.
However, the child must be doing genuine work which will be compensated with an appropriate and comparable wage.
This means that the money must be earned, not just “pocket money” for chores around the house. Plus, the amount of money that you pay your kids must be equal to what you would pay an outside party. This protects their income level but means that their salary can add up, even if it’s minimum wage!
Let’s say you’re a financial planner and you’re looking to outsource paperwork shredding, sorting and filing. This is legitimate work and you could pay your child $10 per hour, for example.
However, if you are simply giving your child an allowance in exchange for performing chores around the house, it would not count as acceptable income for the IRA and contributions to a Roth IRA.
Roth IRA for Kids
In order to make the most of your children’s salaries, they might be eligible to open a Roth IRA account. It can be a great way to save for the future, but the income needs to be earned and not gifted.
Benefits
There are a number of benefits to opening a Roth IRA for your child(ren), including:
Compound interest
Tax advantages
Early Planning for Retirement
Compound Interest
Of course, the major benefit of opening a Roth IRA while your child is young is the number of years that the money can have to grow. Compound interest means that gains are increased in the long-term, with the most significant earnings at the later years of investment.
Over the last decade, the average returns from the S&P 500 have been just over 10%, which add to larger gains over time. For example, the compounding effect means that if you start with a $1,000 investment when your child is 10 years old, add in another $1,000 annually, and the account grows at 7% over the next 10 years, the account would have grown to $16,751 at 20.
You can determine any number of scenarios using this Roth IRA calculator.
Tax Advantages
As a self-employed business owner, you are subject to many different taxes which can take a significant percentage of your income. For example, we recently discussed self-employment tax, with businesses also subject to Tennessee business tax and numerous types of sales tax.
Unfortunately, since a Roth IRA is an after-tax account, contributors do not receive a tax deduction. However, since minors are not subject to taxable income, a Roth IRA is the obvious choice since they will not be issued with tax penalties upon withdrawal of the principal after 5 years (no matter their level of income).
Early Retirement Planning
Of course, the major benefit for your children is knowing that they already have a chunk saved for retirement. However, funds from the Roth IRA can also be withdrawn at any time without penalty (so long as investment gains are not touched). This makes it an attractive choice for that emergency fund we are always going on about!
However, funds from your Roth IRA may also be used towards a first-time property purchase or to pay for college education. The level of diversity to a Roth IRA makes it an alluring option.
Requirements
It’s not quite as straightforward for a minor to qualify for a Roth IRA account as it might be for an adult. There are several strict rules and requirements that must be adhered to, in order to prevent penalties while you pay your children.
As mentioned, your child does need to perform genuine work which is paid “fairly” orat a comparable rate. It’s much easier for your children to be working for other people rather than yourself (for example, mowing lawns in the neighborhood), where they can keep meticulous records.
Record keeping is super important, since your child may be required to prove their income. This is because, after $400 per year in earnings, they must declare their income to the Social Security Administration (even though they are usually not paying any tax).
This income declaration is then what is used to qualify and confirm IRA contributions. These must be equal to the total income earned (as per the declaration) or $6,000- whichever is lowest. Finally, your child must not earn more than $14,000 per year as an upper limit before they have to file taxes.
Maybe you are considering opening a Roth IRA for your kids, or maybe you’re not sold just yet. That’s ok- it’s important to take your time and consider all options when saving and investing your money and trying to save for your child’s future. If you’d like more information about the options available, let’s schedule a call where we can delve deeper into your personal situation and make the right choice for you.
Disclosures:
The S&P 500 is an unmanaged index comprised of 500 widely-held securities considered to be representative of the stock market in general. You cannot directly invest in the S&P 500 index. Past performance is no guarantee of future results.