How to Shift Income to Family Members and Save Money
David M. Bowman
Planning for retirement has never been more important, especially for those in my generation (Millennial) and for the generations that have and are to come after me (Generation Z and Alpha). We will be faced with unprecedented health care costs, staggering college costs for our own children and will most likely live in a time where there may not be social security to rely on. Scary.
If you are part of one of the generations before me, you are probably rolling your eyes at this point and saying to yourself, “Oh give me a break, young people these days are so dramatic and entitled. They want everything, but are not willing to work for it. They are lazy!”
But wait just a minute, what if I told you there is a way to reduce your tax burden, help your children get a head start on saving for retirement and teach them the value of a hard day’s work? If you are a business owner, you are in luck and one of the best parts is that your children will have the opportunity to learn the value of hard work from perhaps the greatest source: You.
Business owners who have children that are of working age, (generally speaking starting at the age of 14) can employ them in roles that are beneficial to their businesses. Wages paid to a child are tax deductible by the business and if wages are less than $6,300, (2016 standard deduction for single individuals is $6,300) the child’s wages will escape federal tax altogether.
A few ground rules:
- The work performed must be done in connection with the owner’s business;
- The child must actually render the services;
- Income earned by the child must actually be paid; and
- Wages must be reasonable in relation to the services performed.
Earned income by the child will open the door for the parent business owner to contribute up to a maximum of $5,500 to a Roth IRA on their child’s behalf. Note, the amount of Roth IRA contribution is limited to the amount of income that is earned by the child.
Mike owns a very successful bakery on the far northwest side of Chicago specializing in German and Polish cakes and pastries. He needed help washing dirty sheet pans which piled up each week and after receiving tax and retirement advice from his ORBA advisor, he hired his 14 year-old son, Josh. Josh quickly learned the value of hard work after being tasked with washing stacks of pans taller than he was day after day. He earned $6,000 the first year and would do so for the next nine years.
For each of the 10 years Josh worked at the bakery, Mike contributed the maximum of $5,500 to Josh’s Roth IRA, which gave him a tremendous head start for saving for his retirement.* In return, Mike’s business received a tax deduction for wages paid to Josh and he also taught his son the value of a hard day’s work and what it meant to bring home a paycheck.
*Assuming a 7% annual investment return, Josh’s Roth IRA balance after 10 years would be approximately $81,000. If Josh made no further contributions, his Roth IRA balance at retirement would be nearly $1,000,000 (assuming he retires at the age of 62 and a 7% annual investment return).
There are not many tax strategies out there that can reduce your tax burden, help your child save for retirement and teach them the value of a hard day’s work. Everybody wins.
Sidebar: Are Taxes Trapped in Your Trust?
Individuals with non-grantor trusts often try to reduce their tax bills by distributing trust income to beneficiaries in lower tax brackets. Generally, trusts are subject to tax only on their undistributed income, while income distributed to a beneficiary is taxed to the beneficiaries at their marginal rates.
However, trust accounting rules limit distributions to distributable net income, which typically includes dividends and interest but excludes capital gains. As a result, long-term capital gains are trapped in the trust and may be taxed at rates as high as 23.8%.
Is there any way to liberate trust capital gains? Depending on applicable state law and the terms of the trust document, it may be possible to include capital gains in distributable net income, either by amending the trust or through an exercise of trustee discretion.
Keep in mind that to comprehensively evaluate the benefits of income-shifting strategies you must also consider any potential gift or estate tax liability, as well as state income taxes.
For more information about tax and retirement savings strategies, contact David Bowman at firstname.lastname@example.org or call him at 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Group.