Hiring kids & Roth IRA

[Shawn H.]

I've read that a business owner can hire their children, then fund a Roth IRA for them since they have earned income. Are there any reasons this would be a bad idea?

[Mike McDermott]

BEWARE! but do it!

When paying your children for services, please be aware of the rules. In brief, here they are:

For a qualifying dependent child, there are four basic tests, any one of which requires a federal income tax return to be filed for a given year:

1. The child has unearned income (from investment interest, gains, and so on) above $1,000.
2. The child has earned income above $6,550. (W-2 income)
3. Gross Income is greater than the larger of $1,000 or earned income (up to $6,200) plus $350. (This combines rules 1 and 2.)
4. Net earnings from self-employment are $400 or more. (1099 income)

So please note, if your business is doing payroll, you can W-2 your children and pay them up to $6,550.

If you simply 1099 them, they have to file after $400!

So for most people, the question then becomes - When does the hassle of doing payroll make sense due to the benefits I get from doing it? If you're earning $10,000 in a side business, it's probably not worth your while.

If, however, you're earning $70,000 in your business, it more than pays for the hassle. Why?

Imagine you have two kids. You can pay them each $6,550 for a total of $13,100. They can put some of that into a SD Roth and also a Coverdell ESA. The rest they stick into a savings account. Let's say they each have a savings account of $2,000. Life has just got a lot better for your family.

1. They have Roth IRAs that are growing for their future. Their Roths are self directed by you, in real estate, and their retirement is rapidly outstripping some stupid mutual fund.

2. The Coverdell ESAs are self directed by you, in real estate, and their college savings are rapidly out-stripping some stupid 529 plan, AND it's staying ahead of rapidly inflating tuitions.

3. Your little girl wants dance lessons and your boy is in hockey. (BTW Hockey is the most expensive sport, what with equipment costs, ice time, travel, etc.) You stop paying for all that stuff, and THEY pay for it now out of their savings accounts.

4. You have an effective deduction for everything on this list! Why? Because your income went down from $70,000 to $56,900 after paying your kids. You only pay tax on the $56,900 but your family got to keep the $13,100!

5. Doing payroll now allows you to claim to operate as an S-Corp, so you save money on Self Employment Tax.

6. You have arranged your business such that you don't mind paying a VA to do your payroll and save you all the hassle.

What do you do if your business is earning between $10,000 and $20,000, so none of the above makes sense at that level? 1099 your kids $399 each and carry on until the above DOES make sense.