In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses kids getting summer jobs, how they are taxed, and, of course, why they should start putting aside money for retirement.
Summer Jobs, Your Kids and Taxes
Hey everyone, I’m Adam Bergman, tax attorney, founder of IRA Financial and welcome to another episode of Adam Talks. Summer is quickly approaching and not sure about you, but I know lots of family, friends and cousins and they’re getting ready for their summer jobs and some even first time they will be working this summer. Pretty exciting stuff if you’ve been able to get to the point where actually someone wants to hire you and pay you to do something. And hopefully it’s a fun summer job. Like a camp counselor or maybe you’re working at Starbucks or working at Walgreens or Walmart or somewhere where you can learn something and at least gain some valuable skills. And I think summer jobs are super important, super valuable. I swept floors and warehouses and worked in retail and did all kinds, kind of not so fun jobs, but learned a lot about responsibility and working with other people and showing up on time and leaving on time and the value of hard work and how hard it is to make a dollar.
So, I can’t wait til my kids are old enough to get a summer job. They’re still a little young, eleven and eight, so they got a couple of years. But I talked to my cousins and some neighbors who are working in summer and they’re kind of stoked because they’re looking to make some money. So, I wanted to do a podcast for all the parents out there who have some kids that are going to be working this summer. Talk about tax filing requirements and obviously what type of tax could be due on those earnings; W-2 versus 1099, withholding taxes and then of course, you know me, I’m going to bring in how you can actually save taxes and potentially save for retirement from your first summer job.
So, basically, it’s kind of simple. There are two types of income. There’s earned income and non-earned income. Earned income is from the performance of services okay? Non-earned income is essentially capital gains, dividend, interest, non-W-2 income, non-employment income, essentially, investment income.
So, basically, if you have a minor kid and earns less than $12,950 in 2022, they will not have to file their own tax return, okay? You’ll basically be able to report them on your return. If they make more than $12,950, they’re going to have to file their own tax return. That’s earned income; income from the performance of services, like being a counselor at camp.
If there’s unearned income, that’s from investment income, the threshold is $1,150. So, if they make under $1,150, they don’t have to follow their own return. If they make over $1,150 in investment income, non-earned income, they have to file their own return, okay?
So, those are the two types of income, the two categories of income. When you’re dealing with summer jobs, you’re clearly looking at earned income. Okay, so the number is going to be the $12,950. If your child dependent earns less, they don’t have to file their own return. You’re going to be able to report them on your return. If they make more than the $12,950, they have to file their own taxes. Now child still owes Social Security and FICA tax. So, a lot of kids will actually pay no income tax and just basically owe Social Security and Medicare, or minimal federal income tax. They’re making $4,000-5,000 and Social Security and Medicare tax is going to eat up most of their income.
So, just something to keep in mind. If the child just has interest, dividends and other income more than $2,200, then there is a specific tax on unearned income that they have to file on Form 8915 and something to keep in mind. Now the Social Security Medicare tax is about 15.3%: 12.4% for Social Security, 2.9% for Medicare. Generally, if it’s a W-2, the employer is going to withhold that. If the employee (the child) is a 1099 independent contractor, then that’s something that child will report on a Schedule C, either on his or her own tax return or on the parents’ tax return.
Now what about withholding taxes? This is an issue a lot of kids get impacted by. So, what some employers do is they’re going to use a pretty high withholding tax ratio; basically assume the kid is going to be working for the employer the whole year, and a lot of the income is going to be eaten up by withholding taxes. Now you could play around with this through an IRS W-4 and lower the withholding or you can just file for a refund, because generally the withholding tax that is going to be withheld from the paycheck probably is going to be more than the income tax owed by the child. So, you can use a W-4 to reduce that threshold if the child is going to want to access some of that cash during the summer, or at least more of the cash, or you can just deal with the withholding rate the employer is using and then file a return. Get a refund when you file your return. So, if you don’t see any withholding, it’s probably because the employer is treating your child as a 1099 independent contractor, which is fine, no problem, it’s the employer’s responsibility to treat the individual correct way, whether it’s an employee (W-2) or a contractor (1099). That’s not the responsibility of the person performing the services, but it’s the responsibility of the employer, the agent of the government. So, that’s not your liability. But, if you see a paycheck or a check or wire without any withholding tax, it’s probably because they’re treating them as a 1099 or you went into the W-4 and picked a very, very low withholding rate. But, if that’s the case, that’s okay, but just know that you’re still going to have to pay the Social Security Medicare at some point.
So what about paying your own kids, right? I’ve done a bunch of videos on this; I think I did an Adam Talks on this several months ago. The key is you need to have a business and you only should pay your kids what you would pay a third party, right? So, cleaning the leaves up in your backyard, taking the trash out. Not a good idea. Why? Because that’s not a business. But, if you have a motel or you have a store and your restaurant and your child is going to be a line chef, or he or she is going to be lifeguard at the pool in the hotel, whatever the case may be, if it’s an employer paying the child, assuming the fees are reasonable, and you’re paying the child for a service, a third party would perform, that’s okay. Okay?
In that case, again, you can pay the child and you get a deduction before you pay the child and the child will then report the earned income if it’s over $12,900 on parents’ tax return; if it’s over, on the child’s own tax return. So, that’s the one thing. Just remember, if you don’t have a business, be careful about paying your kids to do anything, because it probably won’t fly with the IRS.
Now what about your neighbor? If your neighbor wants to pay your kids for babysitting? That’s fine. That’s not a parent, so you have more flexibility or leeway that way. Of course, you want to make sure it’s for genuine services being performed, but in that case, it’s not a parent paying the kids; you don’t need the business setting for that.
So, what happens if your kids make a bunch of money this summer? What do they do? Well, don’t spend it all! They’re young; take advantage of savings. It’s a great lesson. Starts a good habit. A couple of choice: you can go with a pretax IRA if you want your kids to get a deduction, $6,000 maximum. Obviously, you need earned income of at least six. If your kids only make $3,000, you take away Social Security and FICA (15.3%), and then that net amount can be contributed to an IRA. Of course, yes, let your kids spend some of that money. They worked hard for it. You don’t need to save every penny. But, maybe you want to save 20 or 30 or 40% of it. Not a bad idea. You want to take advantage of the power of deferral. Your money grows faster in a retirement account. Why? Because the income and gains are not subject to annual income tax. That takes advantage of the power of compounding returns, which Albert Einstein coined the 8th wonder of the world. Assuming an 8% annual rate of return, your money will double every eight years. So, it’s a super powerful tool.
Roth IRA – $6,000 max. The beauty of a Roth IRA is so long as the child is over 59 and a half, she can pull the money out tax free. Yes, I know they’re going to have to wait 30, 40 years, but imagine how much money will be there in the 40 or 50 years. Even if the child makes five grand, four grand this summer, and even if they don’t put any more money into an IRA for the rest of their life, they could have potentially six figures in 30 or 40 years.
Now, of course, you want to start good habits. This is the point of starting to save for retirement at an early age. This is starting a good routine. So, now your child said, hey, I put away X dollars. I invested it in stocks or bonds or cryptos. And I’ve hopefully seen it grown over the years. Wow, next summer I’m going to keep doing it. And when I get a job after school, I’m going to keep putting away X percentage. And when I start my first job after College, I’m going to max out my 401(k).
It starts the routine, which is a good routine. It’s something all young folks should be learning. Unfortunately, high schools, colleges, not even law schools teach you about IRAs or 401(k)s, right? I always give this example. I went to University, I went to law school. I have a master’s in tax law. I never took one class on an IRA or 401(k).
In fact, I practiced tax law for nine years at major law firms in New York City and never even heard of the Self-Directed IRA world. One of the catalysts for me starting IRA Financial was, I was helping a hedge fund client who wanted to use his IRA to invest in hedge fund. And when I first got the assignment from the partner, I remember thinking, well, you can’t do that. IRAs have to be invested in stocks and mutual funds. This is going to be pretty easy. Well, I figured out and that research time changed my life because I walked right into the Self-Directed IRA world. And I could not believe it. I was blown away that you can actually do real estate and private placements and hard money loans and precious metals and now cryptos and all kinds of cool stuff I have no idea you can do.
So, the idea is that, hey, get young people interested in savings. Watch the savings grow. Whether it’s in stocks or mutual funds or cryptos or some other investment; crowdfunding. Whatever it is. Hopefully, they can see that savings pays off and it will start a very positive routine and something that can change the course of their life, because as they keep doing this on an annual basis, their savings will grow. And Lo and behold, they will have lots of money when they retire.
So IRAs and Roths. Obviously, if you’re younger, you probably want to do a Roth, because, so long as you can be patient and wait and keep those funds in the Roth IRA until you’re 59 and a half, it’s all tax free. Whereas, if you did a pretax IRA, once you’re over 59 and a half, you can pull it all out, but you have to pay income tax. No penalty, but an income tax. Whereas a Roth IRA, it’s all tax free.
Now, if you’re a 1099, right? Remember I said maybe you work somewhere and they’re not treating you as an employee. Maybe whatever task you’re doing, they’re treating you as an independent contractor. You can then set up a Solo 401(k) or even a SEP, but a Solo 401(k) is far more robust. Why? Because you can contribute a lot more money.
For example, let’s say you made $10,000 this summer. SEP IRA would only let you put 20% away or $2,000. The Solo 401(k) will let you go all the way up to 10,000, minus your 15.3% of Social Security and Medicare. So, you can put away a whole lot more money in a Solo and again, the Solo has a pretax and Roth component; also has a loan feature, which you borrow some money if you need it, which, at a young age, you probably don’t need to be borrowing money. And obviously you can still do self-directed investments if you want to do alts.
So, that is only available if you are 1099. If you’re W-2, you work at Starbucks or Walmart, they’re going to W-2 you and you’re going to need to set up an IRA because the SEP and the Solo is only if you are self employed, which if you are W-2, unless you have other income, maybe you sell stuff on eBay or Etsy or wherever else you do things, that’s possible. You can still set up a Solo for that activity, but summer job, if you are a W-2, then it’s going to be an IRA or Roth. Probably want to go Roth because you’re young and you want to lock in your tax-free gains.
But, that’s it. Super exciting time. Everyone loves the summer, right? No school. Things are a little quieter at work, vacation time. Weather is great, except if you live in Florida, not so great. And for kids too; if you’re past the point where you are going to camp, maybe you’re a counselor or lifeguard or get to work at a cool restaurant or cool retail store at the mall, something fun, get to make some money, get to hang out with some cool people, and also learn a lot. I think you’ll learn more; honestly. I remember learning more in the summer than I did at school, because you learn what life is all about. It’s about dealing with, sometimes, people you don’t love, whether it’s a customer, coworker; learning how to handle tough situations. Getting screamed at. I remember I had a customer scream at me at the establishment I was working at; it wasn’t even my fault, but I took it. I just apologized. It was a good lesson because in life sometimes you got to take responsibility for things you don’t do and it’s just some good life lessons; also taught me how hard is the work. I remember coming home and the first week I was just like going to bed at 8:00, I was wiped out and I just realized like, oh my God, school is so much easier than this. Wow. So, I was blown away how hard it is; nine to five for work.
It’s very rewarding to get that paycheck; kind of frustrating sometimes to see the taxes withheld, but that’s c’est la vie. But all in all, for me it was a very valuable couple of summers. I learned a lot; helped me get a really good work ethic, and I think helped me better person, better business person, and even a better student from those experiences.
So, hopefully your kids will have similar experiences, make some money and then, whether they’re W-2, 1099. Now you know about earned income versus unearned income, filing tax returns, no tax returns, tax rates, Social Security, Medicare versus independent contractor; and then also some retirement and tax savings.
Pretax IRA will give you deductions to save taxes on your income you earned this summer, but you’ll have to pay tax when you pull it out after 59 and a half. If you pull out before 59 and a half, you also pay a 10% penalty plus tax. Roth IRA is great, but you got to be super patient and wait until you’re 59 and a half to pull it out. Contributions could always be pulled out anytime, but the earnings on the Roth contributions, which is the juice, that you need to wait until you’re 59 and a half. The Roth will of course be open at least five years.
Or, if you’re 1099, you can do the SEP and the Solo 401(k), which based off my example, and the $10,000 in net income, 20% on the SEP is far less than if you were able to use a Solo K and save, pretty much, dollar for dollar up to the $10,000 minus the 15.3% Social Security and Medicare tax.
So, there you go. That, in a nutshell, is all you need to know about your kids working this summer and some of the tax implications. So, hopefully everyone has a great summer. Yes, I’ll be talking to you next week, so I’m not going anywhere this summer. I’ll be giving you some great content. So, if you’re walking, jogging, or kind of just lounging around the house, hopefully this podcast helps you kind of get through the moment. Pick up a couple of tidbits of information; hopefully have some fun with it as well.
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So, thanks again for spending some time with me today. Have a great rest of your week. And talk to everyone again next week. Take care.