When thinking about saving to fund a college education for their children, many business owners don't think about the tax advantages of hiring their children as an employee. By doing so, you can free up additional funds for college bills. You will also be encouraging your children to become engaged in financing their education.
Smart business owners follow a tax-advantage strategy by directly employing their children and setting aside funds from the child’s earnings into a college savings account. Business owners in high tax brackets can pay for a good deal of their children's education with money that's taxed at the children's rate, which is no higher than 15%.
The core of this strategy is to invest the child's earnings at an early age while they are working for you. This strategy is ideal for the self-employed, sole proprietors and professionals, and it can work for any person who sets up a new business.
Here's how the strategy works. Say you have a 10-year-old child who can do some light office work, which would include anything from weeding out flower beds to simple filing. You pay your child for “jobs related to their age or abilities”. In 2012, the first $5,950 of the child’s earnings is tax-free to them (the standard deduction for a single tax filer). This money can be set aside to pay for their college education.
Assume you have a 15-year-old child who is only three years away from college. A business owner/parent in a 35% tax bracket could save considerable money in taxes by hiring the child and paying him $10,000 for age-appropriate work activities. The business owner/parent’s tax liability on that $10,000 would be $3,500. On the other hand, the child would only have a $450 tax bill ($10,000 minus $5,950 times 10%) which is a $3,095 tax savings to the business owner/parent. The tax savings over a three-year period would equal $9285. Rather than paying the college directly with after-tax dollars, it's obviously much better for the business owner/parent to hire the child and use the tax savings to fund the college account.
Setting up a college savings account is a great way to encourage your child to be proactive towards their college dream. Putting aside funds toward his or her education will give them an added appreciation of the expenses involved in obtaining a higher education. Your child will also learn a valuable savings habit as they set aside money from every paycheck strictly dedicated toward their college education.
There are many options available when it comes to accumulating college savings. Some types of accounts can actually work against the student when it's time to apply for financial aid. Seek advice from your college funding advisor as to which account types will help the financial aid process and which account types will be a hindrance.