If you're a parent, your dependent children can be a source of tax savings. It's likely that you're already aware of more well-known provisions in the tax code like the Dependent Child Care Tax Credit. In this article, we will discuss an opportunity to actually shift taxable income to your children.
Shifting income to your children works because the tax rate increases as your income rises. This provides an incentive to shift income to your lower-earning dependent children.
In 2022, the first $1,150 of unearned income for each child is not taxed and the next $1,150 in unearned income is taxed at the lowest rate of 10%. Typical unearned income includes interest, dividends, royalties and investment gains. Here are three possible ways to do this:
First, transfer enough income-producing assets to each child to approach the annual unearned income limits as closely as possible. Depending on your marginal tax rate you could be saving as much as 37% in federal income tax on the transferred amounts.
Secondly, in addition to the unearned income, consider purchasing investments that will have long-term capital gain appreciation. This may help manage the timing and rate of capital gains tax when the investment is later sold.
Lastly, remember excess investment income could be subject to the additional 3.8% Medicare Surtax. Any investment income that can be shifted to your children could save you this additional tax bite as well.
Income your children make from wages is considered earned income. If you own a small business, finding ways to employ your children can be a way to shift income from your higher tax rate to their lower rate. Care must be taken to be able to defend the work being done by your child and the amount they receive for their work. Some ideas include:
- Use your child in an advertisement for your business.
- Have your child clean your office a few times per week.
- Put your child in charge of making local business deliveries.
- Have your child help assemble items or help with mailings.
If you are a sole proprietor, you may hire your dependent children under age 18 and won't be required to pay Social Security and Medicare taxes.
Moving assets from you to your children could affect their ability to receive financial aid for college. Make sure to consider how your tax strategy affects college financing.
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