An opportunity exists for business owners to pass on a legacy to their children and grandchildren tax-free. By planning ahead of time, you can turn a relatively modest sum of money into nearly a seven-figure account that the children are able to access by the time they retire. The great part is that these monies will be completely free of costly Federal and State taxes as well as free of all estate taxes.
The secret is to hire those children at an early age and fund a Roth IRA with the earnings. Child labor laws don’t apply to a parent for most businesses, but you should check the department of labor to make sure. Once you pass the labor department rules, you are free to hire those kids part time and pay them on the books.
Besides teaching them a life lesson and possibly grooming them for a succession of the business, your plan would include paying them a salary equal to the current Roth IRA deduction; for 2008 that comes to $5,000. Paid over 5 years, you would contribute $25,000 to that Roth IRA while receiving a tax deduction each year for the salary. So if you had a corporate tax rate of 35%, funding a Roth IRA for that child would cost $3,250 after taxes. Now, granted the child may have to file a tax return and pay a modest sum for social security wages; however, the long-term impact of a Roth IRA on their lifestyle at retirement will far outweigh these relatively subtle costs.
When the children grow up and want to purchase their first home, financing can be a challenge. A typical source of funds before a mortgage company is usually- you guessed it- you, the parent or grandparent. Should this scenario occur, you would be prepared to help them by suggesting that they try accessing their Roth IRA that you helped create and funded for them when they were a child. In the past, the government has been generous with tax policy when it comes to first time homebuyers. Therefore, dipping into this Roth IRA before their retirement age will presumably be possible without incurring any stiff penalties from the IRS. Although there is no guarantee this will be the case in the future, dipping into their Roth IRA will always be an option verses other less favorable and perhaps more costly scenarios including your child or grandchild becoming a perpetual renter or having to take out large loans.
Below is a chart of a hypothetical Roth IRA with $5,000 invested each year from age 15 to age 19 (for a total of $25,000 invested over 5 years) and these funds compounded annually at 8% interest until the age of 63. In this illustration, the account value would soar to over $900,000, all tax-free.
If today’s current generation of youth intends to retire comfortably, they will have to start their financial planning process earlier and save more money than any generation before them has ever had to. As an independent business owner, you have a unique advantageous ability to help them get a head start on that planning while receiving preferential tax treatment in the process.
The above hypothetical assumes an 8% annual rate of return, which may or may not be
achieved. It is for illustration purposes only. Consult your tax advisor before
implementing a plan such as this.
Rick Cross contributed this report.