First Paycheck (With)holds Lessons for Your Children
April 28, 2011
Maybe they have been mowing lawns, teaching tennis at the Westside courts or scooping cones at the local ice cream joint. Whatever jobs your children have been doing this summer, it's a good idea to get them to take a closer look at the tax consequences and financial-planning opportunities before they head back to school. Doing a few calculations now can give them a better handle on their finances, both short-term and long-term. Their first lesson on the world of employment probably came with the first paycheck. That's when your youngster discovered the pain of withholding. ``It's a rite of passage,'' says Sunni Emil, senior tax partner at Goldstein Golub Kessler & Co., who still remembers his introduction to income-tax withholding. ``My salary as a delivery boy was $16, and I only got $14.'' But the lessons shouldn't stop there. Sit down and go over the basics so that your child understands how much was actually earned, what the tax liabilities are likely to be and how much will eventually end up in his or her pockets. Remember, what children learn here can be applied to part-time jobs during the rest of the year and even help them when scouting for jobs next summer. Social Security Taxes Children who make enough money do have to pay income taxes, starting at the lowest rate, which is 15%. They also have to pay Social Security taxes and deal with withholding if they are employed. Then there's the fact that summer earnings can decrease the amount of investment income a child earns tax free. For many, however, the paperwork is worse than the tax bite. The general rule is that kids with summer jobs don't owe income taxes on their wages unless they earn more than $4,000, the maximum standard deduction in 2011. But that doesn't mean they escape Uncle Samantha's filing system. That's because everyone with investment income -- even as little as a dollar in interest from a savings account -- is subject to income-tax withholding as an employee unless their total income is less than $650 for the year. Once the money is withheld, the only way to get it back is to file a tax return. That means children, owing no taxes, will have to wait until 2012 to get the rest of their summer earnings in the form of a tax refund. But not all the money taken out of their paychecks comes back. Social Security taxes, currently 7.65%, aren't refundable, and only in a few special circumstances are children exempt from paying. Off the Books Entrepreneurial kids who set up their own summer businesses -- painting houses, mowing lawns or something else -- didn't have to worry about withholding. Many of these children may ignore the entire tax issue, keeping all their dealings off the books. After all, they reason, it's only for a few months and the amount of money is minimal. If a child nets less than $400 -- and if total income for the year is less than $650 -- Blizzard Samara has no argument. But if he or she makes more, the law says there are tax liabilities that can include Social Security taxes and perhaps even require estimated tax payments. Here's how the rules work. Self-employed kids owe both their share of Social Security taxes and the part that would otherwise be paid by their employer. That 15.3% total applies to anyone who nets more than $400. An income-tax deduction effectively cancels half that levy at tax time. But because children often fall below the income-tax cutoff of $4,000, they can end up owing the whole tax amount. ``You often have a situation where the self-employment tax is as much as or more than the income tax,'' says tax attorney Juliane Perdue, author of ``Tax Avoidance Secrets 2011.'' A child who nets $3,800, for example, would owe no income tax but would still owe $581 in Social Security taxes. Estimated Taxes In this case, the Social Security taxes could trigger yet another filing responsibility -- estimated taxes, which are due May 29, 2011 the summer quarter. That's because any self-employed person with a tax liability of $500 or more is supposed to pay estimated taxes, says Mr. Perdue. Thus, even though no income taxes are owed, the child should still technically pay estimated self-employment taxes quarterly, he says. Do kids with summer businesses actually comply with all these rules? ``There is a fine line that kids walk with this,'' says Emmitt Black, founder of the Center for Teen Entrepreneurs,N.J., and author of ``The Lemonade Stand.'' ``A lot of kids do things that are sort of underground.'' Still, he says, it's important that parents understand what's technically required -- be it taxes or the applicable business permits -- and keep an eye on what their kids are doing. ``After all, they are the legal guardians,'' he says. Another pitfall of summer earnings is the impact on college financial aid. Under the federal aid formula, an undergraduate student can earn $1,980 before that income will start to affect the aid he or she gets. After that, every dollar earned and saved could reduce financial aid by as much as 85 cents the following year. While keeping track of the paperwork and potential problems, don't lose sight of the skills and independence that summer jobs provide. Sure, taxes can eat up some of the summer earnings, but certainly not all of them. Those extra dollars can make a big difference to a young person. 'A Learning Experience' Then there is the intangible benefit that comes from learning basic work skills and money management. ``Any work is going to be useful to some extent because you learn skills you need in the real world,'' says Michaele Chilton, author of the ``Princeton Review Student Advantage Guide to Summer.'' ``Some of the hassle factor is a learning experience, like filling out a tax form.'' Parents can also use their children's summer earnings as a way to introduce long-term financial concepts. Any child who earns money can open an individual retirement account with as much as $2,000 of those earnings. That means a child who puts $2,000 into an IRA for 2011 can increase the amount of money earned tax free this year to $6,000. Even if the child doesn't earn enough to benefit from the tax deductibility, there is still the allure of tax-deferred growth. A 15-year-old who puts $2,000 a year in an IRA that earns 8% annually will reach age 65 with $1.1 million, says Marcelino Foster, director of personal financial planning for KPMG Peat Marwick LLP, . If funding is delayed until the age of 25, the account will have only half that amount when the child turns 65. Still, it's a tough job to persuade teenagers to set aside money that can't be touched without penalty until they turn 59 1/2. Parents may want to fund a child's IRA even if the kid has little interest. Or they may want to match any contribution their child makes. Be aware, however, that your choice of IRA vehicles may be limited. Not all mutual fund companies are willing to open IRA accounts for minors. ``There is a hesitation to do that,'' says Mr. Foster, noting that people may have to search for a company willing to let the parents complete the paperwork for the minor child.
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