When parents claim their children as dependents, these children may be subject to the so-called “#kiddie tax.” This tax generally affects children under 19 and full-time students aged 19-23. It was introduced to prevent parents from reducing their tax liabilities by transferring investments to their children, thus taxing unearned income at the parents’ higher tax rates.
The #kiddie tax applies to unearned income (investment income) exceeding a certain threshold. For 2024, if your child’s investment income surpasses $2,600, it will be taxed at your highest marginal tax rate. Earned income (income from work), however, is taxed at the child’s rate, benefiting from the standard deduction for singles, which is $14,600 for 2024. This means your child can earn up to $14,600 from working without owing federal income tax, although Social Security and Medicare taxes will still apply. If your child contributes to a traditional IRA (with a 2024 cap of $7,000), they could earn up to $21,600 tax-free.
Even if your child is reluctant to part with their earnings, you, a grandparent, or another benefactor can gift them the amount for an IRA contribution. This not only jumpstarts their retirement savings but also instills a habit of saving early.
If you own an unincorporated business, hiring your child can yield tax benefits. Paying a reasonable salary to your child reduces your self-employment income and shifts income to them. For example, if you are in the 22% tax bracket and pay your child $16,500 in 2024, you can reduce your income by this amount, saving $3,630 in income tax. Meanwhile, your child would only owe $190 in taxes on $1,900 of taxable income (after the standard deduction).
Moreover, if your child is under 18, they are exempt from FICA taxes (Social Security and Medicare) when employed by a parent’s business. This saves both you and your child from paying these taxes. Additionally, it reduces your self-employment tax.
Assume your business profits are $180,000. By paying your child $16,500, you lower your self-employment income, saving $442 in Medicare taxes (2.9% of $16,500). If your net profits are below the maximum SE income limit of $168,600, you save an additional $1,889 in Social Security taxes (12.4% of $16,500), totaling $2,331 in tax savings.
FUTA (Federal Unemployment Tax Act) provides further savings, as it exempts wages paid to a child under 21 by their parent’s business from federal unemployment tax. These exemptions also apply to partnerships solely comprising the child’s parents but do not extend to incorporated businesses or partnerships with non-parent partners.
Encouraging your child to contribute to a traditional IRA with their earnings can provide additional tax savings. For 2024, they can contribute up to $7,000. This can combine with the $14,600 standard deduction, allowing them to earn up to $21,600 without paying federal income tax. However, if the tax savings are minimal (e.g., $190 on a $7,000 contribution), a Roth IRA might be more beneficial due to its future tax-free withdrawals.
Understanding the #kiddie tax and employing effective tax strategies can significantly benefit your family. Encouraging early savings and making the most of tax deductions not only reduces current tax liabilities but also sets your child up for financial success in the future.
