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The Kiddie Tax: How It Works and Strategies to Save

Thinking about your child’s future? It’s never too early to start them on the path to financial responsibility. This includes understanding how taxes work. For dependent children, there’s a concept called the “kiddie tax” that applies to unearned income (think investments). Let’s break down what it is and explore some strategies to make the most of your child’s earnings.

What is the Kiddie Tax?

Imagine a time when parents could transfer investments to their children’s names to benefit from lower tax rates. The kiddie tax was introduced to prevent this. It applies to unearned income exceeding a certain amount for children under 19 and full-time students between 19 and 24. This unearned income is taxed at the parent’s marginal tax rate, which can be significantly higher than the child’s rate.

The Bright Side: Earned Income Gets a Break

There’s good news! Your child’s income from working (earned income) is taxed at their own single rate. In 2024, the standard deduction for single filers is a generous $14,600. This means your child can earn up to $14,600 without paying income tax (though Social Security and Medicare taxes still apply).

Boosting Savings with IRAs

Want to jumpstart your child’s retirement savings? If they’re earning income, they can contribute to a traditional IRA. For 2024, the contribution limit is $7,000. Let’s say your child earns $14,600 (tax-free) and contributes the maximum to an IRA. That’s a total of $21,600 and zero income tax! Even if your child doesn’t want to contribute their own money, consider gifting them the amount for an IRA contribution. It’s a fantastic way to jumpstart their retirement savings habit.

Employing Your Child in Your Business?

Running your own business? Here’s a strategy you might not have considered: employing your child (under 19) and paying them a reasonable salary. This reduces your self-employment income, lowering your tax burden. The child’s income itself is taxed at their marginal rate, with a lower standard deduction than yours. However, the first chunk of their earned income enjoys a tax benefit.

For example, let’s say you’re in the 22% tax bracket and pay your child (with no other income) $16,500. You save $3,630 in income tax, while your child has a taxable income of only $1,900 (after the standard deduction). The tax on that? Just $190! In this scenario, the family saves a net of $3,440.

Bonus Tip: FICA and FUTA Tax Savings

There’s more to this strategy! When a child under 18 works for a parent-owned business, they are exempt from FICA taxes (Social Security and Medicare). This saves on both the employee and employer sides. Similar exemptions apply to FUTA (unemployment tax) for children under 21. These exemptions only hold for unincorporated businesses or partnerships solely consisting of parents; incorporated entities or partnerships with non-parent partners don’t qualify.

Maximizing Savings: Retirement Plans and Beyond

The strategies go even further! If your child earns more than the standard deduction allows, they can contribute the excess to a traditional IRA and deduct it from their taxable income. Additionally, depending on your business’s retirement plan and your child’s age/work hours, they might even be eligible to participate.

Remember, Roth IRAs Might Be a Better Choice

While a traditional IRA offers tax-deductible contributions, the Roth IRA allows for tax-free withdrawals in retirement. Considering your child’s long time horizon until retirement, a Roth IRA might be a more strategic choice, even if it means slightly less tax savings today.

The Takeaway: Knowledge is Power

The kiddie tax might seem complex, but with careful planning, you can help your child navigate it and maximize their financial future. If you have further questions or want to explore specific strategies, feel free to contact our office for personalized advice.

JS Morlu LLC is a top-tier accounting firm based in Woodbridge, Virginia, with a team of highly experienced and qualified CPAs and business advisors. We are dedicated to providing comprehensive accounting, tax, and business advisory services to clients throughout the Washington, D.C. Metro Area and the surrounding regions. With over a decade of experience, we have cultivated a deep understanding of our clients’ needs and aspirations. We recognize that our clients seek more than just value-added accounting services; they seek a trusted partner who can guide them towards achieving their business goals and personal financial well-being.
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