By Dr. James M. Dahle, WCI Founder
Kids are great. They're lots of fun to wrestle on the carpet. They say the darndest things. Every now and then they make you cry. I've been practicing my lines for when my oldest daughter shows up at my house with a guy:
“Son- you need to know two things about me….#1 I love my daughter very much and #2 I'm not afraid to go back to prison.”
Kids are also useful for lowering your taxes. It's a little known secret that multi-generational tax planning can be highly effective, both for estate taxes and income taxes. Today, however, I'm only discussing the generation below yours, and I'm only discussing income taxes.
Dependent Exemption
The first way kids are very useful is that you get an exemption for each one of them, as long as they are dependent on you. For 2014, that's $3,950 deducted from your adjusted gross income (essentially a below the line deduction that doesn't require itemizing). Given my 33% marginal tax rate (28% Federal, 5% state), my kids are worth $1,304 a piece, per year. Exemptions phase out too, and within the range of incomes that many physicians enjoy. In 2014, the phase-out begins at an AGI (1040 line 38) of $254,200 ($305,200 married) and ends at $372,500 ($427,550 married). That's another great reason to maximize your retirement account contributions and other above the line deductions if you're in that range.
The Child Tax Credit
Some people even get a child tax credit in addition to the exemption. However, most attending physicians make too much to get this credit. In 2014, this credit is phased out at an AGI of $75,000-$95,000 ($110,000-$130,000 married). Although it is based on a modified AGI, if you can't deduct student loan interest, you probably can't get the child tax credit. For the poor (like medical students) who don't pay taxes or even have negative taxes, there is even an additional child tax credit, which is refundable.
Using Your Kid's Tax Brackets
There is some big savings available by using your childrens' tax brackets. Just like in retirement when you want to “fill-up” the 0%, 10%, and 15% brackets with IRA/401(k) withdrawals, during your career it would be best (from an overall family wealth perspective) to fill up everyone's 0%, 10%, and 15% brackets. How big are these brackets for your children? Well, it depends on whether it is earned or unearned income. Earned income is best, since the 0% bracket (standard deduction) is $6,200, the 10% bracket is $18,150, and the 15% bracket is another $55,650. However, it is pretty tough for a kid to earn that much.
Unearned (investment) income can also be useful, but the standard deduction (0% tax bracket) is tiny, just $1,000. There is a 10% bracket, another $1,000, but above that their unearned income is taxed at your maximum rate, not a good thing.
So if you have four children, and can shift $24,350 in earned income and $2,000 in unearned income to each of them, the total tax bill on that $105,400 would be $7,660. If that money were all taxed at your 33% rate, the bill would be $34,782. Shifting the income saves you $27,122. But wait, it gets even better. The savings might not be quite that much, since your children would have to pay payroll taxes on their earned income, but you get the point.
Tax Breaks for Hiring Your Child
How can you shift income? It's very easy to shift unearned income, that's why the brackets are so tiny. Shifting earned income is more difficult- your business needs to hire your kids. They can work for your clinic, your website, your rental property etc. You don't have to hire them as employees; you can also contract with them as independent contractors. They obtain work experience, they earn some spending money, and the overall family tax bill is lowered. You can go one step further and contribute those earnings to a Roth IRA, establishing important saving and investing habits early. Imagine Roth money that is invested for 6 or 7 decades before being spent! The kid might not be interested in using his hard earned cash for retirement, but money is fungible. You can “match” his earnings, giving him what he earns as a gift while putting the earnings into the Roth IRA.
“But my kid is too young to work,” you say. Not necessarily. You've seen all those pictures of kids in magazines, catalogs, and on the internet. Why shouldn't they be paid a modeling fee for their effort? What's a fair modeling fee anyway? Surely your kids are so pretty they should command a hefty sum. Don't get carried away. Remember you may have to justify the sum to an auditor someday. (It turns out $300 a day is probably a reasonable sum. $3,000 a day probably isn't.) Don't be surprised if you start seeing more pictures of my kids on this website.
UGMA/UTMA Accounts
The way to shift unearned income to your children is to give them the money by investing it in a UGMA/UTMA account. This probably isn't the place to put college money, 529s and ESAs are probably better for that in most instances. But for money you would like to give your kids anyway, to help with a down payment, a mission, buying their first car, a wedding etc, an UGMA (Uniform Gift to Minors Account) or UTMA (Uniform Transfer to Minors Account) is the perfect choice. There are slight differences between the accounts (the UTMA is a little more flexible) and they are governed by state law, but in general the basic concept is that you control the money until the child turns 18-25, and the kid can blow the money on whatever he wants.
In exchange for using that account, the earnings are taxed at the kid's rate. That means the first $1,000 in earnings is tax-free, and the second $1,000 in earnings is taxed at just 10%. Any earnings above $2,000 is taxed at your rate, the infamous “kiddie tax.” But $2,000 in earnings is a heck of a lot if the account is invested in a very tax-efficient manner. Consider an index fund which kicks off 2% a year in long-term capital gains and qualified dividends. You could have $100K in this account before any of it is going to be taxed at your rate. If you have more than that, you can start investing it in I bonds, zero coupon bonds, or even a municipal bond fund. When your child is in his 20s, and probably in a very low tax bracket, he may not even have to pay long-term capital gains taxes upon withdrawal! (Remember that the LTCG tax rate for those in the 10% and 15% bracket is 0% these days.)
Tax Loss Harvesting
You can even tax loss harvest and tax gain harvest these accounts. I've been carrying a $400 loss forward for years in my daughter's account. One year I even “updated the basis” by harvesting some gains (but less than $1000 so it was a tax-free update). I'm not sure the tax gain harvest is really worth it if current law remains in place, since I anticipate it will all be withdrawn tax-free anyway in her 20s, but it certainly didn't hurt.
If you are facing what seems to be an unfair amount of taxes, consider doing some multi-generational tax planning, and take advantage of your childrens' low tax brackets to lower your own taxes.
Have you hired your children? Do you use UGMA/UTMA accounts? Why or why not? What pitfalls have you run into? Comment below!
All good information and very helpful. But unless you have lots of free time, making sure you get it all right is probably a trade off. Rather than knowing all the ins and outs to get it right, my suggestion is to make sure you have someone on your team who does know how to do this for you. That way, rather than spening time to develop new skills, use your people skills which you already have to find the right team member, and go back to doing what you know how to do best, which is creating good patient outcomes. That’s something I have no idea how to do; but I do know how to create good financial outcomes for physicians.
I think you overestimate how much time is required to understand the concepts discussed in this post.
I also think you overestimate the ease of getting good advice at a fair price from financial professionals. I think the evidence is quite clear that the “people skills” that physicians have are not adequate for selecting high quality financial professionals to assist them.
This is a tired argument that the time spent following these concepts comes at the expense of patient outcomes. [While most physicians may not watch the 30+ hours that the average American spends watching TV, you know where the time is going to come from. It’s certainly not at the expense of patient outcomes.] Most planners would rather sell you insurance on your children before suggesting that you pay your children. In fact, rarely will they bring this concept up, because they would rather sell (yes, sell) you some form of useless whole life insurance. I’m wondering what the effect of UGMA/UTMA is on financial aid? I understand that any funds in the child’s retirement account (IRA or Roth) do not adversely affect financial aid.
UGMAs have a dramatic effect on financial aid as it is the kid’s money. That said, if you have the money to fund an UGMA, the only financial aid your kid is going to qualify for is going to be loans, which isn’t really aid at all. So I wouldn’t worry about it too much.
It is a laughable argument that a physician or dentist who spends time researching his/her investments will then subject his/her patients to non-ideal care. I have many medical and dental colleagues who spend more time per week researching different Bourdeauxs or learning the ins and outs of their BMWs than I spend on my investment strategies. Do you think the wine dealer tells them their patients are going to suffer over it?
“rather than spening time to develop new skills…, go back to doing what you know how to do best, which is creating good patient outcomes”
Great idea. I will stay static and not develop new skills for the rest of my life.
Since dividends are anyway taxed at 15% for adults, isn’t it better to earn interest than dividends in UTMA account?
I suppose if your choice is between putting the interest-generating investment into your taxable account or your kid’s taxable (UTMA) account, then yes, put it in the kid’s account. But I think that’s probably a false choice for most.
Am I missing something, how are you avoiding the kiddie tax?
I take it back, you did mention it indirectly. I’d avoid anyone having to calculate kiddie tax, it’s extremely painful.
Yes, the goal is to avoid the kiddie tax completely by keeping the UGMAs relatively small and tax-efficient.
I really like the idea of contributing as much as possible to a child’s roth IRA. First, it can lead to a really comfortable retirement with 60+ years of compounding interest. Second, money can be pulled out for education and for home purchase, the two main reasons a younger person would want to break into such a nest egg. And third, financial aid formulas won’t account for retirement accounts, so it’s essentially a favored college savings account if you need.
Do I have to use a UTMA/UGMA account to take advantage of this tax benefit? If I were to open a savings account or buy I-bonds in my child’s name, would I avoid taxes on the interest from these accounts yet still maintain control of the money?
Any time you open an account in a kid’s name it’s an UGMA/UTMA account. Doesn’t matter if it is at a bank, a brokerage, or a mutual fund company. Beyond a certain point, the earnings are taxed at your bracket (the kiddie tax.)
2 questions/comments:
1. I don’t fully understand the unearned income shelter. In order to use this wouldn’t the investment accounts have to be in your kids’ names? I guess under age 18 you still control that money, but after 18 would you then transfer that money back in to your own name or risk your kids making a poor decision at a young age with a hefty sum of money?
2. You forgot to mention the Childcare/Daycare Tax deduction. Although it’s not much I use it every year!
Once you give the money to the kid by putting it in an account in their name, you can only spend it on stuff that directly benefits them. So you control, but you can’t then transfer the money back to yourself when they turn 18/21. It’s theirs to blow on coke if they want.
I agree the childcare would have been a great deduction to mention. I’m considering filing a 1040X for last year to get a couple hundred bucks back for what I spent on preschool for my son.
Update- You can’t take this deduction unless the reason the child is in daycare/preschool is because you (both parents) are working or looking for work. If you have a stay at home spouse like me, you don’t qualify.
I hired my kids during the summer for years at a non-medical family business I own. Lots of hours of hard manual labor. Good for them, good for their college funds, good for my tax bill. As they got older, I had them sorting receipts and helping with bookkeeping on weekends around tax season, and paid them for that, too.
There was absolutely nothing that I couldn’t do for myself, and it would have been a waste of money to hire someone else to do my payroll, keep my business records, and file their tax returns. It was a great opportunity to teach them how to fill out and file their own tax returns (and to indoctrinate them into the importance of finding every legal way possible to deprive the IRS of as many of your hard-earned dollars as possible.)
Yes, regulations and rules are tougher now than they’ve ever been. When my dad hired me every summer while I was growing up, he just paid me a lump sum at the end of the year and wrote it off on his taxes as labor. He would never have dreamed of having a problem with the IRS over a lack of record-keeping. Those days are over, but in the era of Quickbooks and the internet, there is little you can’t do for yourself if you have common business sense — and common sense regarding what you will be able to defend in an audit.
I probably paid my kids twice what I might have been able to find someone else to do the work for, but would have had no problem defending it in an audit. They are already under my insurance, they are no liability risk to me if they get hurt, when they were young, I legally didn’t have to pay Social Security taxes on them, they had guaranteed longevity as employees, they had a sense of ownership that made their work higher quality that I wouldn’t have been able to get from someone off the street, etc.
As long as you aren’t doing some sort of questionable tax dodge, you don’t need professional help. BTW, I just saw a child today whose mom got her a job at age 5 working for a clothing manufacturer. $150/hr to try on clothes to check the fit of their designs, more for any modeling done for the catalog. So let’s start seeing some photos of your kids, and my heart will warm at the thought of your tax benefits!
Hiring you kids is a financial “no-brainer.” No physician posting on this forum will get a dime of need-based aid for their kids’ college. Don’t even consider it in your calculations. No Soc Security payments if under age 18. No Kiddie tax on earned income. Issue them a W-2 every year using filetaxes.com.
Don’t get greedy… no $25 hour job for a 2 year old.
Timely post. I’m in my first year out of fellowship, and have only recently been trying to educate myself on better managing my finances for the long term. The wife and I are expecting our first in December, and so I’ve been trying to figure out how best to use our first-born to our (tax) advantage.
Also, just wanted to say thanks for the work you do here; it’s made a huge impact. Since I started reading your blog several weeks ago, I canceled my whole life policy (just in time to avoid my first premium payment). That plus your post on the Backdoor Roth IRA, will go a long way in helping me towards my financial goals. All the other great information your site has provided me with will help me get there even faster. I only wish I’d come across your site a few years ago!
I like this idea for paying for private high school, but I’m not seeing where there is much savings (I”m justing thinking about unearned income). So the idea is to invest just enough money so that the yearly taxable gains are <$2000? I don't think that would be too hard with a Tax efficient Vangaurd index fund. But, when you go to sell the stocks then do you pay capital gains tax at the parents rate? If so, doesn't seem to save much money if you're using a tax efficient fund anyway for cash investments?
Is this account protected against parents’ creditors/malpractice judgements? Is it ok to use money from a UTMA to pay for private school as one comment mentioned?
Also, I have stocks in my own account that have significant long term capital gains if I were to sell them. Could I transfer these to a UTMA and reset the cost basis to the current value?
If anyone knows…thank you!
Yes, you can burn it on private school, but an ESA may be a better option for that. It is the kid’s money, so it’s exposed to the kid’s creditors, but not the parent’s. No, you can’t transfer them to a UTMA. That would be a cool trick though. Just swap securities back and forth between two people to reset the cost basis.
My kids have earned income this year and they want to open a Roth. I was abe to help them with everything except the beneficiaries. None are married or have kids obviously, so who did you designate as beneficiaries?
How about each other? Or you?
How does a UGMA have 100K in it before it is taxed at the parent’s rate? What’s the scenario you’re describing? Sorry, that statement was a little confusing to me.
Only the income is taxed. So if it’s all invested in TSM with a 2% yield, the first $1000 is tax-free and the second $1000 is taxed at the kid’s rate. Above that, it’s taxed at the parent’s rate. So you could have ~$100K in a total stock market fund before you’re paying taxes on it at the parent’s rate.
How does Kiddie tax impact UTMA when the child liquidates – i.e., on capital gains? Assume much higher than $2K. Say the child is a full time college student when they liquidate the funds, are all of those capital gains taxed at the parent’s cap gains rate (15 or 20%) or at the parent’s income marginal tax bracket (24, 32, 34%, etc.)?
The definite answer should be on Form 8615 and its instructions.
https://www.irs.gov/pub/irs-pdf/f8615.pdf
https://www.irs.gov/pub/irs-pdf/i8615.pdf
Who Must File
Form 8615 must be filed for any child who meets all of the following
conditions.
1. The child had more than $2,200 of unearned income.
2. The child is required to file a tax return.
3. The child either:
a. Was under age 18 at the end of 2021,
b. Was age 18 at the end of 2021 and didn’t have earned
income that was more than half of the child’s support, or
c. Was a full-time student at least age 19 and under age 24 at
the end of 2021 and didn’t have earned income that was more than
half of the child’s support.
(Earned income is defined later. Support is defined below.)
4. At least one of the child’s parents was alive at the end of
2021.
5. The child doesn’t file a joint return for 2021.
For these rules, the term “child” includes a legally adopted child
and a stepchild. These rules apply whether or not the child is a
dependent. These rules don’t apply if neither of the child’s parents
were living at the end of the year.
Support. Your support includes all amounts spent to provide the
child with food, lodging, clothing, education, medical and dental
care, recreation, transportation, and similar necessities. To figure
your child’s support, count support provided by you, your child, and
others. However, a scholarship received by your child isn’t
considered support if your child is a full-time student. For details,
see Pub. 501,
Wow. So it’s until age 24 or until they’re supporting themselves, whichever comes first! Not 18 or even 21 when it becomes their money in my state. I’m kind of surprised.
As far as capital gains rates vs ordinary income tax rates, you can also figure that out from Form 8615 lines 9 and 10. Looks to me like it uses Schedule D in the calculation so I think that means you’ll pay at your LTCGs rates on LTCGs and dividends.
Line 9
Figure the tax using the Tax Table, Tax Computation Worksheet,
Qualified Dividends and Capital Gain Tax Worksheet, Schedule D
Tax Worksheet, or Schedule J (Form 1040), whichever applies.
If line 8 includes any net capital gain or qualified dividends, use
the Qualified Dividends and Capital Gain Tax Worksheet in the Form
1040 or 1040-NR instructions to figure the tax, unless you have to
use the Schedule D Tax Worksheet or Schedule J (see below).
Thanks for another great article. I am a regular reader of your web site for some time now. Ran into this old article while looking for information about hiring my 16-year old daughter for my business.
You have mentioned the option of hiring kids as independent contractors. While searching online, I could only find information about hiring our kids as employees. Do you know of any web sites or books with information about hiring them as contractors and possibly comparing the two options?
How about this one:
http://www.irs.gov/taxtopics/tc762.html
That article is about classification of a worker. I am looking for the differences, if any, in tax planning, strategies and gotchas of hiring kid as IC vs employee.
Although I have since realized that specifics about working as an IC should not be different for a kid other than any legal requirements and the tax treatment will probably be same for earned income whether it’s from working as an employee or IC.
Thank you for highlighting this tool for family wealth management and multi-generational tax planning. In principle this is a no-brainer but I have some concerns:
I am a physician employee of a hospital system. Is there a way for me to hire my children if I am not a small business owner, have no rental property, no LLC, and am not a member of a private practice?
My children are 2 and 5, and I can not imagine any task they could perform to earn income other than modeling for photographs. The reasonable rate of pay seems like a gray area rife with potential for auditor’s scrutiny. Let’s say I want each child to earn $5,500 annually so they can max out their Roth IRA contributions annually, and I pay them for photos on my personal professional website (which I have, despite being a hospital employee). I would not want my professional physician website to be inundated with a huge personal family photo album (potentially compromising professional credibility…), so I am paying them $5,500 each for 1 or 2 photos? At $15/hr (for example), that would be over 366 hours of work to obtain a few photos. Does that pass legal muster?
If this is legally acceptable, it seems I am still paying my children with my after-tax dollars, thus nullifying any immediate family tax benefit (although still gaining the long-term tax benefit in the Roth IRA). Do I take a deduction on my tax return for wages paid to children, so they are being paid with pretax dollars?
If you don’t have a business, you can’t hire them. What do you mean your “professional physician website?” You mean something owned by your employer? That’s not your business. If your website isn’t a business that makes money then you can’t hire somebody to work for it.
And no, I don’t think paying $5500 for a couple of photos is legit. But $100 an hour for modeling probably is.
By “professional physician website” I mean a website I created with Squarespace for my patients to obtain information about me and my practice. It is separate and distinct from my hospital employer’s hospital website. It is not a personal website about a hobby or recreation, but rather created with the intent of supporting and augmenting my profession as a physician, which is my sole source of income.
It sounds like, as an employee, this is unfortunately a moot issue for me. If I become a member of a private practice (LLC) in the future, I will pursue this. I will also investigate whether it would be worth the hassle to start an LLC while employed in the hospital setting, for the purpose of utilizing this tax planning tool.
Lastly, if I had a business and found 55 hours worth of work for my kids to complete at $100/hr, do you compose a pay stub or work hour log to keep on file? I envision a simple word document listing dates work performed, brief description of work performed, hourly rate, and gross pay, paid to kids in cash. Then if IRS wants to see documentation, the word doc is what you would provide. How do you document your kids’ work?
I agree, moot issue for you unless you start moonlighting.
I’m just getting started with my kids but I’ll have a job description/contract if the IRS comes asking. I’m not planning on paying them $5500 though. Nothing they can do is worth that much right now.
So the only reason one would open an UGMA or UTMA is to get the lower taxes on earnings?
Think of an UGMA/UTMA as the kid’s taxable account. It’s money that you want to give to your kid. The fact that some of it is taxed at a lower rate is just bonus.
I am going to lose the deduction for kids now that my 3 boys are all above 18 years old. Can I set up a UGMA/UTMA for them and deduct that on my 1040?
The answer to your question is no, an UGMA contribution is not deductible.
However, be aware that there is a new $500 dependent credit that some or all of your boys may qualify for.
Since the standard deduction is now up to $12,200, it might be a good time to take advantage of that by hiring your kids and lower the overall taxes. We have been utilizing our 2 kids (ages 13 & 11) to do some home office and assistant-type work for a few hours a week (more in the summer) since the beginning of the year. Now we are thinking about making this official from a tax standpoint, but I have a few questions;
– I’m assuming we would then file 3 different tax returns (one joint return for the family, then 2 individual returns for the kids), correct?
– They would still be our dependents on the main family joint tax return, right?
– Do we need to actually issue them any 1099 forms or other paperwork?
– Would it be necessary to setup separate bank accounts for them? and is it ok to continue paying them in cash?
Thank you!
It was a good idea to hire your kids before.
Correct.
Correct.
W-2s, W-3s etc.
It would be wise.
Thanks for the reply. Why W2/W3 and not 1099? W2 employment status seems to require more paperwork and filing requirements, compared to being 1099. Also 1099 status would allow them to have more deductions of their own (work-related expenses, etc) down the line. is there a down side to putting them on 1099 status?
It does require more paperwork, but you don’t have to pay payroll taxes if the parents are the only owners of the non-corporation business. If you pay them as independent contractors, payroll taxes must be paid.
I thought you don’t have to pay payroll taxes either way but may be I was looking at outdated info. That’s good to know.
Now do we need to get an EIN at this point to issue the W2/W3 forms, etc? Since it’s almost November, is it too late to account for work they did in 2019 or we can still file the paperwork come tax season? It’s been all cash so far. I also believe there shouldn’t be any withholdings in their W2’s since their total income will be around $12000 each for the year, so still below the standard deduction. I’m trying to figure this out & understand all the details, since my local accountants actually don’t seem to fully comprehend this!
Why wouldn’t a self-employed business owner have to pay payroll taxes? I’m not even sure a minor can own a business, can they? It appears to be state specific:
https://thelawtog.com/legalities-running-business-not-yet-18-years-old/
At any rate, what you want to do is employ them. Technically there are steps you need to do to hire someone before you start paying them. You have to formally hire them, check their immigration status, have them fill out a W-4 etc. I’m not going to tell you to fudge the dates on all that, but I suppose if you want to do so it is your right.
I have 3 sons. If I open a UTMA for each child… do I hit the ‘kiddie tax’ based on EACH child’s invested earnings being over $100K or is it the sum of the total, i.e. $33.34K each x 3 = $100K ? Hope I am asking that correctly.
Thanks.
Each kid gets their own kiddie tax limit before your tax bracket kicks in.
I just opened an UTMA for my child to make investments and allow for some portfolio diversification. What strategies should I consider before the unearned income exceeds the $2k limit? The child is just now 16 yrs of age.
Two things to keep in mind:
# 1 Before they owe any tax you can invest however you like, so pick the best investments without regard to tax consequences.
# 2 However, keep in mind that they may be stuck with some gains down the road, so what you choose does matter in that respect. A UTMA is just a taxable account for your kid. It only functions differently until they’re 18/21.
https://www.whitecoatinvestor.com/retirement-accounts/the-taxable-investment-account-2/
I have a 15 yr old and two grand kids age 5 and 7
Is it a good idea to have UTMA or 529?
Thx
Probably, but impossible to say without more information.
How much is a reasonable amount to pay your own child as a voice actor in a self-employed business? Is the payment a recurring one or a one-time payment?
$100 an hour seems justifiable. But if they do one 10 second clip and you want to pay them $1000 a month that’s probably not going to be okay.