Here’s one of the top questions that I get…
“How can I reduce my taxes???”
It’s a great question to ask!
I would ask you several questions right back.
Are you paying yourself first and maxxing out your current retirement plan?
Are you utilizing a second retirement plan?
Have you done the Roth IRA, the back door Roth IRA or the Super Back Door Roth IRA?
Outside of these common pieces of advice…
In my opinion, some of the best tax deductions can come from being a business owner.
However, there’s also a little known deduction that many business owners haven’t considered.
Did you know that hiring your family can lead to huge tax deductions?
What If You Hire Your Kids?
If you have children as bona fide employees and they are under the age of 18 working for a parent-owned unincorporated business, you are exempt from paying their SE/FICA taxes. That’s a savings of 15 percent!
“Payments for the services of a child under age 18 who works for his or her parent in a trade or business are not subject to social security and Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child. Refer to the "Covered services of a child" section below. Payments for the services of a child under age 21 who works for his or her parent in a trade or business are not subject to Federal Unemployment Tax Act (FUTA) tax. Payment for the services of a child are subject to income tax withholding, regardless of age.”
Now, there is a limit to what you can pay them and to totally AVOID all federal income taxes and FICA taxes (keep in mind that state income taxes are different).
The standard deduction in 2021 is $12,550.
This means anything you pay them up to $12,500 is ENTIRELY tax free!!!
Now that they’ve been paid that amount…
What should happen with that money???
What if they saved it?
Since they have earned income, that means that they can contribute up to $6,000 in a Roth IRA PER year. The money in the Roth IRA can compound and grow and grow. Then one day when they buy a house, they could use up to $10,000 in that Roth IRA for their down payment without paying any taxes on the withdrawal.
Keep in mind that the kids need to legitimately do some work.
This article has 51 different ideas that kids could do and be legitimately paid for.
Now remember… this particular benefit ONLY applies to business owners that have an unincorporated business.
Only someone like myself with an S-Corp where I pay myself a W-2 wage, this does NOT apply to.
What If You Hired Your Spouse?
Perhaps, instead, you have a corporation. Does your spouse help out now and then with your business? Do you have your spouse on the payroll?
By adding them to the payroll, you may be able to add them to the company’s retirement plan (SEP, SIMPLE, 401(k), etc) and dramatically increase the contributions as well as utilizing a company health savings account (HSA) and potentially lowering insurance costs.
Let me explain the power of this benefit.
Let’s say that you employ your spouse and you pay them W2 wages of $25,000.
Let’s also say that you have a solo 401k where you can sock away tax-deferred money for yourself as well as your newly hired spouse.
Not only can you make employee contributions, but you can ALSO make employer contributions.
So, your spouse with wages of $25k will have to pay FICA taxes of about 7.5% and you as the employer will also have to pay FICA taxes of about 7.5%. Good news is that your spouse is building social security credits and will have payments to them in the far future! So you can potentially get some or all of that tax paid back to you. It’s a very, very long term investment.
On top of that, if they are under 50 years old, you will be able to tax-defer $19,000 of employee contributions and get a tax deduction today for that. If they are over 50 years, you could do the whole $25,000!
Also, the employer (i.e. you), could choose to make a employer contribution of up to 25% of your W2 wages for you and your spouse.
That’s another tax deduction of $6,250 right for your business!
Imagine if this is super charged with a defined benefit plan like a cash balance plan ON TOP of the 401k.
Forbes has a good primer on defined benefit plans if you aren’t familiar with them.
Not only might you be able to do what I just described--- but if you are like some of my clients--- depending on the wage paid, you might be able to sock away another $50,000 or $100,000 or $200,000 or even $300,0000 ON TOP OF THE 401K.
Keep in mind that the contribution to the defined benefit plan is based on several criteria.
- How much you are being paid (the higher it is the higher the contribution)
- Your age (the older you are, the higher the contribution)
- The amount you have already funded in the plan (there is a max of a few million currently) vs the suggested amount. You may have under or overfunded the plan in the past which can lead to higher or lower future contributions
- It’s based on 3 year rolling averages. So, if you had a low wage paid 2 years ago, that may impact your contributions for the next year or two.
A defined benefit plan truly allows you the ability to sock away a TON of money.
However, it’s not all cute kittens and rainbows, there are some drawbacks.
- It’s a minimum of a 3 year commitment. You can’t just do it for 1 year.
- You are making a commitment to putting away a certain amount of money with minimum amount of contributions.
- There’s also more costs with a defined benefit plan. You have to hire a third party administrator which will charge $1,500 to $3,000 for doing the actuarial work.
All that being said, it’s a wonderful opportunity for the right situation.
Hiring family members can lead to some wonderful opportunities and tax deductions for the right situation.
You could hire a child and not have to pay ANY taxes.
If you have the ability to save a lot, you could hire your spouse and have a 401k and/or a defined benefit plan.
Make sure you review over your situation with a tax professional to ensure that these are the right moves for you.
If you have any questions, please feel free to reach out to me at firstname.lastname@example.org
Material discussed is meant to provide general information and it is not to be construed as specific investment, tax, or legal advice. Individual needs vary & require consideration of your unique objectives & financial situation.