Suppose you hire your child at age 14 to help with some basic needs at your business, such as filing or copying, and pay that child a reasonable hourly rate for the services rendered. That child will pay no federal income taxes on this earned income as opposed to you, the parent, who would pay tax on this income at a high rate. Further, if you organized your business as a sole proprietorship or a single member LLC, you do not have to withhold or pay Social Security taxes until the child turns 18. Even if your business is structured differently and you have to pay Social Security taxes, this strategy will still save you income taxes in excess of the cost of the Social Security taxes.
As your child gets older, he or she can work summers and after school and make a higher hourly rate. In 2008, if you can justify their salary as reasonable, you can pay the child up to $5,450 and the child still pays no federal income taxes. In fact, it can get even better, because the earned income permits the child to contribute up to $5,000 to a traditional deductible IRA. Therefore, the child could receive up to $10,450 in compensation and still pay no federal income tax.
The idea behind a Roth IRA account is that the contribution you make to such an account is with after-tax dollars but the income earned over the years will generally grow tax-free. The earlier you fund a Roth IRA, the bigger the tax savings. The key to making Roth IRAs is that you must have earned income. So, hiring children early and establishing a Roth for them allows that income to grow tax-free generally for the rest of their lives. In 2008, if a child has earned income up to $5,000, they can contribute all of it into a Roth account. Further, any contribution, but not the income, can be withdrawn at any time without tax implications. So, if the child needs the money for college or later in life for a house, those contributions can be withdrawn tax-free. Parents can set up a custodial Roth IRA and control these investments until the child reaches the age of majority.
If you, the parent, are in a high tax bracket, you generally do not qualify for a $2,000 lifetime learning credit for your college-age child. Under a loophole in this tax law, if you waive the dependent’s deduction for this child, the child can qualify for their own $2,000 credit. What this means is that a child can earn up to $21,458 in 2008. The child will owe $2,000 in taxes but can use the $2,000 credit. In other words, the child pays no taxes on this income.