With summertime approaching, many children will be getting jobs during their school break. Others will continue at their part-time jobs throughout the summer months. What does a child’s work mean to the child and his or her family from a tax perspective?
Tax Considerations for Children
A child can earn for the year up to the amount of the standard deduction for his or her filing status. For 2017, this amount is $6,350 for a single individual (Rev. Proc. 2016-55, 2016-45, 707). Thus, a child can earn over $18 per hour (based on a 35-hour week for 10 weeks) without any income tax on the earnings. The “kiddie tax,” which subjects a child’s income over a threshold amount to the tax rates of the parent, only applies to unearned (investment) income and not to earned income (Code Sec. 1(g)). A child who expects to owe no federal income tax can file an exemption from income tax withholding on Form W-4, Employer’s Withholding Allowance Certificate. This exemption can be used only if the child had no tax liability in the prior year and expects none this year.
Of course, exemption from income tax withholding has no effect on Social Security and Medicare taxes (FICA). A child must still pay these taxes on any amount of earnings (unless the child works for a parent’s company as explained later). Thus, the child’s wages are reduced by 7.65% for FICA taxes.
The child can use his or her earnings to fund an IRA or Roth IRA. The contribution limit for 2017 is $5,500 (Code Sec. 219; Notice 2016-62, IRB 2016-46, 725). If the child opts to use a traditional IRA, then earnings up to $11,850 ($6,350 + $5,500) are tax-free. The contribution need not be made by the child, who can save or spend his or her earnings. The contribution can, for example, be made by a parent or grandparent, to the child’s account up to the lesser of the child’s earnings or $5,500. If it becomes necessary to tap into the IRA in order to pay for higher education, the distributions are taxable, but there is no 10% early distribution penalty in this case (Code Sec. 72(t)(2)(E)).
Usually, because of the long savings horizon until retirement and the child’s low income, it may be better to contribute to a Roth IRA (Code Sec. 408A). No deduction can be claimed for the donation, but earnings become tax-free. If the child does not want to be saddled with investment decisions or risk any losses, contributions can be made to a myRA, which is like a mini-Roth IRA. More information about myRAs can be found through the Treasury (https://myra.gov/).
The child cannot claim the retirement saver credit, which allows taxpayers to double dip (i.e., get a tax break for the contribution and a tax credit) (Code Sec. 25B). The credit is barred to anyone who can be claimed as another taxpayer’s dependent.
Tax Considerations for Parents
The fact that a child works and earns money does not prevent the parent from claiming a dependency exemption for the child ($4,050 in 2017). As long as the child is under age 24 and a full-time student, and the child does not provide more than half of his or her support, has the same principal place of abode and is a member of the parent’s household (when not away at school or for other temporary purpose) the exemption can be claimed (Code Sec. 152(c)).
If child support is being paid on behalf of this child, working at a summer job usually does not affect the amount of payments. However, parents should check their divorce or other relevant agreement to determine whether a child’s working has any impact on child support.
Putting Your Child on the Payroll
It can be a win-win situation for a parent who owns a business and hires his or her child for the summer. The child earns income and gains work experience. The parent gains a tax advantage and enjoys the additional help.
The parent can deduct wages paid to a child as a business expense. A deduction is allowed only if the compensation is reasonable for the work performed. It is advisable to document the hours worked and the type of services performed by the child in case the IRS questions the parent’s return. For example, in one case where a parent with a tax preparation business used her three children to do clerical work, she was denied a deduction for payments because she did not issue them paychecks and could not show any correlation between work performed and the amount of the payments (Ross, TC Summary Opinion 2014-68).
If the parent is a sole proprietor or a partnership in which each parent is a partner, wages paid to a child under age 18 are exempt from FICA (Code Sec. 3121(b) (3)(A)). Wages paid to a child under age 21 are exempt from FUTA (federal unemployment tax) (Code Sec. 3306(c) (5)). These exemptions do not apply if the parent’s business is incorporated or if the parent’s business is a partnership where each partner is not a parent of the child.
The earnings of a child can impact financial aid received for higher education. The Free Application for Federal Student Aid (FAFSA) allocates half of a student’s income for the upcoming college year. Income includes money from working (other than work-study income) and withdrawals from IRAs. A parent’s income contribution ranges from 22% to 47%. The FAFSA for the school year between July 1, 2017, and June 30, 2018, can be submitted any time between October 1, 2016, and June 30, 2018. The income reported on the 2017-2018 FAFSA is 2015 income (i.e., the 2015 income tax return).
Also consider that the financial aid formula requires a child to use 20% of his or her assets; parents are only required to use 5.64% of their assets. However, “protected assets,” such as funds in IRAs and Roth IRAs, do not factor into this computation.
For students and parents, now is the time to think about summer employment. Companies are filling their openings now and families should plan accordingly.
Executive Editor Sidney Kess is CPA-attorney, speaker and author of hundreds of tax books. The AICPA established the Sidney Kess Award for Excellence in Continuing Education in his honor, best-known for lecturing to over 700,000 practitioners on tax. Kess is senior consultant for Citrin Cooperman and is consulting editor to CCH.