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Dealing With Retirement Benefits as an Employer

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In the third part of his series on the benefits of employing your children, financial guru Julian Block goes in-depth on Social Security taxes and retirement savings accounts like Roth IRAs. You'll learn about IRS rules and other details, all of which you should communicate to your clients.

Jan 27th 2021
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Two previous columns discussed often-overlooked tax breaks available in 2021 for freelancers, consultants and other self-employed individuals who pay their sons and daughters reasonable wages for work actually done by the children on behalf of their businesses. You can read about TCJA tax benefits and more.

Adding children to payrolls keeps businesses profits within families while shifting some from higher brackets of parents to lower brackets of sons and daughters. This column focuses on Social Security taxes and Roth IRAs.

Freelancer Nadine hires Eli, her 14-year-old son, to work in her office after school, on weekends and during school vacations. She pays him $10,000.

Nadine is in a combined federal and state bracket of 30 percent. Her deduction for Eli’s wages of $10,000 decrease her income taxes by $3,000. Just how much Nadine actually saves depends on whether Eli’s wages are subject to Social Security and other payroll taxes.

Some twists and turns in the rules for Social Security taxes. Generally, the wages Nadine pays Eli and other employees are subject to Social Security (6.2 percent) and Medicare taxes (1.45 percent). They aggregate 15.30 percent (7.65 percent for both employer and employee).

But Internal Revenue Code Section 3121 (b) (3) (A) authorizes an exemption for Nadine and other parents. They don’t have withhold Social Security and Medicare taxes on wages that they pay to their under-age-18 sons or daughters.

When does Nadine qualify for the exemption? Only when her business is a sole proprietorship, meaning she’s the lone owner of a full-time or part-time business that’s not formed as a corporation or partnership, or is a partnership in which the only partners are Nadine and Eli’s other parent.

What disqualifies Nadine? When she incorporates her family business or is in a partnership with a partner other than her spouse.

Whatever income self-employed Nadine is able to shift to Eli lowers her Social Security taxes by as much as 15.30 percent. Translation: a valuable exemption of $15.30 for every $100 of wages paid.

For 2021, the 15.30 percent rate applies just to the first $142,800 of Nadine’s net self-employment earnings (receipts minus expenses), up from $137,700 for 2020. The rate is 2.9 percent on net earnings above $142,800, up from $137,700 for 2020.

Eli, too, sidesteps Social Security taxes of 7.65 percent on his wages. Translation: an exemption of $7.65 on every $100 of wages received.

Roth IRAs. Eli’s 2021 standard deduction of $12,550 for earned income erases income taxes on his wages of $10,000. He has the option to put part his wages of $10,000 into a Roth IRA–as much as $6,000 for 2021.

The source of that $6,000 needn’t come out of his $10,000. It can be a gift from say, Nadine or his grandparents.

Sure, he gets no 2021 deduction for his Roth contribution. But the write-off would have been worthless because of that standard deduction.

There are big benefits for contributions to Roth IRAs that were created to encourage retirement savings. They grow without being taxed. Another break for Eli is that he can withdraw contributions (but not earnings on them) at any time, without being burdened by taxes and penalties on withdrawals, which could prove helpful in the event he needs funds to cover unexpected expenses.

There are restrictions on earnings. Generally, he’ll be able to withdraw earnings free of taxes only after he attains age 59 ½, by which time they’ll have swelled enormously.

My next column covers how the courts usually side with IRS determinations that the “wages” paid by parents to their children actually were nondeductible allowances or spending money for the children.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 350 and counting). 

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