Photo by Juan Pablo Serrano Arenas
"One day, you will all be millionaires," said Mrs. Edmonds, my 3rd grade teacher at David Crockett Elementary in my hometown of Marshall, TX. The year was 1976.
I was considered a "hyperactive" kid, now known as ADHD (Attention Deficit Hyperactivity Disorder), but that day she had my undivided attention. I don’t recall if we were being taught math or some other topic, but after she made the statement, I remember she talked about how milk and bread prices from the 1930s were much lower than they are today due to the impact of inflation, and that same impact would eventually mean everyone would be a millionaire. I didn’t realize that the lesson I was really learning was the power of compound interest, but I did realize that I was going to be a millionaire!
Several years later, in college, I took a finance class that taught me to use an HP calculator’s financial functions to determine future values, present values, and internal rates of return. This new-found skill reignited in me the fascination I had in 3rd grade that one day I could be rich, given enough compound interest and time. Learning how to play these "What If..." games on a calculator became somewhat of an obsession that ultimately led me to my career in personal finance.
One of the best things about my job is that, in the course of helping people plan for their future, I now get to play these games for a living. The other day, I was talking to a client who owns a business. He mentioned that his 15-year-old child had been helping him out this summer. I asked how much he was paying his child for the work?
"Why would I want to do that?" he asked. He already costs me an arm and a leg!"
"You may be able to save several thousand dollars in taxes AND give him a good chance of having over a million dollars tax-free later in life," was my reply.
"I’m listening," he said.
The strategy I was referring to isn't new, but many business owners fail to take advantage of this valuable tax break while also giving the next generation a great head start on their retirement. I advised my client, as I would anyone reading this, that it would be prudent to consult with your tax advisor to assure that you don’t inadvertently step on any tax landmines.
For this to work, your child must perform some sort of legitimate work for your business. Let’s use my client’s situation as an example. His business is a sole proprietorship form of ownership (the rules vary by business type) and his 15-year-old child is helping out with some bookkeeping part-time and over the summer. My client is in the 37% federal tax bracket.
In 2023, the standard deduction amount is $13,850. In other words, you can deduct that amount from your earned income when calculating your income tax burden.
My client thinks his child could legitimately earn around around $250/week for their work, or around $12,000 annually.
The $12,000 he would pay them is a business expense that, instead of being taxable income to my client at 37% ($4,440), would be taxed at his child’s rate. If the child doesn’t have any other income, the $12,000 would not exceed their standard deduction, so the entire amount is effectively be tax-free.
In addition, because the child is under the age of 18, my client won’t be obligated to pay any Social Security, Medicare, or Unemployment (FICA and FUTA) taxes on the amount paid, saving around another 9.15% ($1,098) that he may otherwise have had to pay an employee. (The savings would be less if he is just paying himself due to different rules for the FICA and FUTA).
In this example, that would be a tax savings of up to $5,538. Not bad.
In my best Emeril Lagasse impression, I said, "Now let’s kick it up a notch"! Let’s say you invest the tax savings in a Roth IRA for your child until they turn 18 and invest in stocks, mutual funds, or ETFs. If they can average 10% (approximately the long-term average of large company stocks), the Roth IRA would be worth $18,331 by age 18. If they never put another penny in the account and it continued to average 10% until age 65, it would be worth $1,616,748.
“Ready to really get crazy,” I asked? Earn 12%, which just happens to be the average of small-cap stocks over the long term, and it will grow to $3,770,798. Even crazier, if your child sees the benefits of regularly saving for the next 47 years and decides to contribute $5,538 every year until age 65, they will have $13,217,982 tax-free!
Isn’t this a fun game?
Using tax strategies and investment vehicles like Roth IRAs can be powerful tools for building wealth over time. However, it's important to note that financial planning involves various factors and considerations, and individual circumstances may vary.
While the scenario presented highlights the potential tax savings and growth of investments over time, it's crucial to remember that investment returns are subject to market fluctuations and that past performance is not indicative of future results. Additionally, tax laws and regulations can change over time, so it's essential to stay informed.
It's also worth mentioning that focusing solely on financial gain should not overshadow other important aspects of personal and family well-being. Teaching children about money management, savings habits, and responsible spending can be valuable life lessons that extend beyond financial success.
While the strategy outlined can have its merits, it's crucial to approach financial planning holistically, taking into account your individual circumstances, market conditions, and potential risks and rewards.
If you would like to discuss your financial plan, get in touch. If not, at least you now know what an arm (and maybe a leg, too) may be worth in 2073.