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In a recent article ("6 tax reasons why you should put your spouse on the payroll"), we pointed out several tax benefits for hiring a spouse. But your “better half” isn’t the only family member you can add to the payroll.

Strategy: Give your children after-school jobs this fall. By doing so, you can reduce the overall family tax bill. Also, putting a child on the payroll can avoid adverse "kiddie tax" consequences.

Similarly, if a recently graduated child works full time for your company, he or she may be eligible for certain tax-free employee benefits, just like other employees.

Here’s the whole story: Currently, the kiddie tax applies to a child who is under age 19 or a full-time student under age 24 whose earned income does not exceed half of his or her annual support. (In its previous reincarnation, the tax was limited to children under age 18.) Thus, the kiddie tax will affect many college students and high school graduates in 2010.

If the unearned income received by your child exceeds the annual kiddie tax threshold ($1,900 for 2010), the excess is taxed at your top marginal tax rate. Therefore, a family may be penalized if you’ve invested funds in a child’s name to pay for college or other expenses.

But remember that the kiddie tax applies only to unearned income. If your child is paid wages for actual work, the payments are exempt from the kiddie tax. For instance, if a business owner in the 33% tax bracket pays a child to work part time in 2010, the child may receive the entire amount tax-free up to the amount of the standard deduction ($5,700 for 2010). The wages are also tax-deductible by the business. Conversely, if the owner personally received the same amount in income, he or she would owe at the 33% rate.

Other tax benefits at the job

As an official employee, the child may be in line to receive tax-free company fringe benefits or take advantage of other tax breaks. Here’s a sampling:

•    Insurance: A child may receive health insurance coverage under a group plan. The health insurance protection is 100% tax-free. Also, the first $50,000 of group-term life insurance coverage paid on behalf of the child is tax-free. With both insurance plans, the premiums paid by the business are tax-deductible.

•    Retirement plans: The child may participate in a 401(k) or other qualified retirement plan and contribute within the allowable tax law limits (i.e., $16,500 for a 401(k) in 2010). Although withdrawals generally aren’t allowed before age 59½ without a 10% penalty, the funds accumulate on a tax-deferred basis.

•    IRAs: Once a child has earnings from a job, he or she can sock away up to $5,000 in a traditional or Roth IRA. Since the child’s income is low, the contributions to a traditional IRA can be deducted on his or her personal return. Contributions to a Roth IRA are never tax deductible, but the funds may eventually be withdrawn tax-free.

•    FICA and FUTA: If a child under age 18 is employed by a parent’s sole proprietorship or husband-wife partnership, the earnings are exempt from FICA. This exemption also applies to FUTA tax until age 21. These payroll tax breaks can represent significant tax savings—especially when added to the income tax savings discussed above (see box below).

Tip: Don’t be greedy. The child must be paid a “reasonable amount” for services performed.

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