“One day, you will all be millionaires.”
It was 1976 and I was sitting in Mrs. Edmond’s 3rd grade math class at David Crockett Elementary in Marshall, TX when she made that statement. She was discussing the impact of inflation, also using milk and bread prices from the 1930’s to demonstrate the power of time and inflation on purchasing power. All I could focus on was that I was going to be rich!
In college, I took a finance class that used the same bread and milk example to explain the power of compounding. We also learned how to use an HP calculator’s financial functions to calculate 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 over time. It even became somewhat of an obsession that ultimately led me to my career in personal finance. Some folks like to play Angry Birds, I like to play “what if” I stop drinking coffee and put the savings in the stock market for the next 20 years. I’m a wild and crazy guy, what can I say?
One of the best things about my job is that in the course of helping people plan for their future, I get to play my “what if” games for a living. The other day, I was talking to a prospective client who owns a business. He mentioned that his 15 year old son had been helping him with his website. I asked if he had ever considered putting his son on the payroll.
“Why would I want to do that?” he asked. He already costs me an arm and a leg!”
"What if you could give him $1,500,000 tax free while saving a couple of thousand dollars per year?” was my reply.
He was all ears.
The strategy 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.
First, you need to hire your child to do some sort of legitimate work for your business. For this example, let’s assume a sole-proprietor form of ownership (the rules vary by business type) with a 15 year old child helping out with some bookkeeping and website maintenance. Further assume that you are in the 39.6% federal tax bracket. Here’s how it would look starting in 2015.
You can pay your child up to the standard deduction amount of $6,300 without either of you incurring federal income tax liability. The wages (assuming they are reasonable) you pay to your child while a minor are deductible to you as a business expense. For your child, the standard deduction eliminates their tax obligation.
If you pay your 15 year old $6,300, you save $2,485 that you otherwise would have paid in federal income taxes had you taken the income for yourself. FICA and FUTA taxes may also be exempted up to certain ages, but for our example today we’ll just focus on federal income taxes.
So you start with at least $2,485 in tax savings. Not bad.
This is where it gets wild. Instead of blowing it on video games, what if the 15 year old put $5,500 of that income into a Roth IRA each year just until they turn 21 and invest in a stock, mutual fund, or ETF? If they can average 10% (approximately the long term average of large company stocks), the Roth IRA would be worth $42,436 by age 21. If they never put another penny in the account and it continued to average 10%, at age 60 it would be worth $1,746,020.
Ready to get crazy? Earn 12%, which just happens to be the average of small cap stocks long term, and keep contributing $5,500 every year until age 60 and the child will have $7,470,265!
Isn’t this a fun game?
If nothing else, we now know what an arm and a leg may be worth in 2060.