The wages you pay to your child must be reasonable for the work that he or she performed (so, for instance, you can't pay your child $200 an hour for filing).
Anyone with earned income can open an IRA. If you open an IRA for your child, the money contributed to the account can be deducted from the child's income on his or her tax return.
Setting Up an IRA for a Minor
Let's take our example one step further. Say your child really wanted to get that Mustang running and worked extra to earn $7,850. At 35 percent, your deduction for his wages is worth $2,747 in tax savings. But his standard deduction is limited to $4,850, making his taxable income $3,000. No worries: You can contribute $3,000 to an IRA account set up for him. Your child reports his $7,850 in wages on his return, shows a $3,000 deduction for the contribution to his IRA, takes the $4,850 standard deduction, pays no taxes, and starts saving for retirement.
It gets even better if you've set up a SIMPLE retirement plan for your business. A SIMPLE plan allows employees to contribute up to $8,000 per year to the plan.
SIMPLE IRAs for Minors
In this case, your child reports $13,850 in wages on his return, shows a $8,000 SIMPLE contribution deduction, and takes the $4,850 standard deduction, resulting again in a taxable income of zero. At a 35 percent tax bracket, your payment of $13,850 in wages saves you $4,847 in taxes.
Of course, setting up a SIMPLE plan is more involved than just opening up an IRA account. Many financial institutions will be happy to point you in the right direction if you're considering this option.
Give Stock, Cash, or Other Income-producing Property
You can give up to $11,000 per year to anyone without paying any federal gift tax (until you give away one dollar more than a million bucks, total, in your lifetime, at which point the gift tax kicks in).
The gift tax is a special tax under the estate tax system, assessed when you transfer money or other property to someone else. Our estate tax system works like this: If you die with a good-sized estate, your estate can be subject to estate taxes as high as 48 percent of the value of your assets.
The gift tax is designed to prevent you from transferring your assets to others before you die in order to avoid estate taxes. However, the Internal Revenue Code graciously allows you to give up to $11,000 per year per recipient without gift taxes being assessed. Unfortunately, giving away $11,000 only eliminates the paying of gift tax. You may not deduct the $11,000 on your income tax return.
How does this benefit you as far as your children are concerned? If you transfer income-producing property worth up to $11,000, or $11,000 in cash ($22,000 for married couples), per year, any income produced by the transferred asset is taxed at your children's lower tax rate instead of your rate.
Be careful, though. This really only works if your child is 14 or older. Why?
- Children under 14 who have income from investments (basically interest and dividends) greater than $1,600 are usually taxed at their parents' tax rate. Their income is added to their parents' income to get the effective tax rate.
- If your child is 14 or older, the income from those investments is taxed at the child's normal tax rates, which are probably lower than yours.
Note that your direct payments for tuition or medical care for your children don't count as a gift for gift tax purposes.
Contribute to a State Tuition Program
State tuition programs (also called 529 Plans) allow you to prepay future tuition expenses. The earnings on these accounts grow tax-free until you withdraw the money to pay for college or other post-secondary schooling. The key is that the money must be spent on college or other post high-school education.
Contributions to state tuition programs are subject to the gift tax, which means you can contribute up to $11,000 to each recipient's account per year without having to pay gift taxes. However, if you want to make one large contribution, you can contribute up to $55,000 in one year and have the annual $11,000 gift tax exclusion apply ratably over the next five years. The exclusion doesn't apply if you make additional gifts to the same child within those five years.
State tuition programs have the potential to provide large tax savings over a number of years. As mentioned above, any accumulation in the account (such as interest, dividends, appreciation) is not taxed. In addition, distributions from the account are completely tax-free if they are used to pay for higher-education expenses. Qualified expenses include tuition, fees, books, and reasonable costs for room and board, as long as the beneficiary is enrolled at least half-time.
Contribute to an Education Savings Account
You won't save much on taxes, but you can contribute up to $2,000 per child to an Education IRA, now known as an Education Savings Account. The contribution isn't deductible, but the earnings on it are tax-free, and will remain tax-free as long as your child withdraws the money from the account to pay for college or other post secondary-school educational expenses.
Set Up a Custodial Account
You can transfer up to $11,000 to each child each year, and avoid the gift tax on that amount. From then on, any income on that property will belong to the child, who must pay the taxes on it, probably at a lower rate than you would pay (assuming the child is 14 or older).
For each state has a Uniform Gifts to Minors Act (UGMA) or a Uniform Transfers to Minors Act (UTMA) that covers ownership of assets by children. Essentially, any accounts that you set up for your children are custodial accounts, and you, the custodian, have a fiduciary responsibility to manage those accounts for the benefit of your child. When your child reaches the age of majority (set by your state), control of the account is transferred to him or her.
Any account that you set up for your child will carry your child's social security number, and the account's earnings will be taxed to the child. If the child is under 14, earnings in excess of $1,600 will be taxed at your tax rates.
Transfer Cash or Assets to a Trust
Fifteen or so years ago, you could set up short-term trusts for your child, let the income be taxed to them at lower rates, and then have the principal revert to you at about the time your child entered college. This nice little tax-reduction strategy was eliminated in 1986: the income from this type of trust is now taxed to the grantor (usually, that's you).
There are still a couple of trust possibilities, however.
The Minor's Trust
You can set up a minor's trust (otherwise known as a "2503(c) Trust" after the Internal Revenue Code section that governs it) where you transfer principal (cash, real estate, and so forth) to the trust, and control the income and principal of the trust until your child reaches age 21. At that time, the minor's trust must terminate automatically or you must give your child the right to withdraw the trust's assets within 60 days. You can specify in the trust document that the trust will continue until a later date (which you specify) if the child doesn't withdraw the trust's assets.
What are the benefits of this type of trust?
- The trust pays taxes on the income, not you. It's a separate tax-paying entity and you must file income tax returns (Form 1041) for the trust each year.
- You can take advantage of the trust's income tax rates. For example, for 2004:
The first $1,950 of taxable income is taxed at 15 percent.
The next $2,650 is taxed at 25 percent.
The next $2,400 is taxed at 28 percent.
The next $2,550 is taxed at 33 percent.
And the rest is taxed at 35 percent.
What this means is that any income from the minor's trust is taxed at a rate lower than yours. If you hadn't transferred the assets to a trust or if you had given the assets directly to your child under 14, the earnings on the assets would have been added to your other income and then taxed at your rate.
The Crummey Trust
Another commonly used trust is the Crummey trust, named after D. Clifford Crummey, who was the first taxpayer to use this trust successfully. This type of trust can be used for anyone, not just minor children.
The trust is similar to the minor's trust described above, with a few important exceptions. One is that Crummey trusts do not automatically terminate when your child (the beneficiary) reaches the age of majority. The person who establishes the trust decides when the beneficiary will receive distributions, and the trust can even continue over the beneficiary's lifetime.
A disadvantage of the Crummey trust is that any time you make a gift of property into the trust, the beneficiary must be given the right to withdraw the contribution during a specified time frame; it is locked in the trust until you decide it should be distributed.
And You Can Keep on Giving
You can make yearly contributions to both types of trust—the minor's trust and the Crummey trust—using the $11,000 per beneficiary annual gift tax exclusion.
