Paying Children and Grandkids: The Earned Income Roth IRA, Family Employment, and Wealth Transfer Strategy

Family employment is one of the most powerful and underused tax planning strategies available to small business owners. Properly structured, paying children and grandchildren for legitimate work converts what would be after-tax allowance or gift dollars into pre-tax business deductions, allows the children to fund Roth IRAs at their own (often zero) tax bracket, and shifts wealth across generations without consuming gift tax exemption. The combined benefit can amount to tens of thousands of dollars annually.

The Foundation: Bona Fide Employment

For wages paid to children to be deductible, the IRS requires:

• Real work performed — actual services that the business needs.

• Reasonable wages — comparable to what an unrelated third party would be paid.

• Age-appropriate tasks — generally older than 7 for any meaningful employment.

• Proper payroll administration — W-2 issuance, withholding (where applicable), employment tax compliance.

The IRS has aggressively challenged sham employment arrangements where children received "wages" for services they couldn't credibly perform. Documentation matters: a written job description, time logs, and records of actual work performed are essential.

The Standard Deduction Sweet Spot

For 2025, the standard deduction for single filers is $15,000. A child with $15,000 of earned income from family employment owes zero federal income tax on those wages — the standard deduction fully shelters the income. State tax may apply depending on the state.

Combined with retirement contributions, a child can earn substantially more without federal income tax:

• Standard deduction: $15,000

• Roth 401(k) contribution: $23,500 (if business has a 401(k))

• Traditional IRA contribution: $7,000

• Total earned income with no federal income tax: $45,500 (varies based on entity structure)

The FICA Exemption for Children Under 18

One of the most powerful aspects of family employment: children under 18 employed by a parent's sole proprietorship or by a partnership owned exclusively by both parents are NOT subject to FICA tax (Social Security and Medicare).

This exemption applies to:

• Sole proprietorships (Schedule C / single-member LLCs).

• Partnerships where both parents are the only partners.

The exemption does NOT apply to:

• S-corporations (FICA applies regardless of relationship).

• C-corporations.

• Partnerships where a non-parent is also a partner.

For a sole proprietor paying a 16-year-old child $15,000:

• Federal income tax: $0 (sheltered by standard deduction).

• FICA tax: $0 (under-18 exemption).

• State income tax: varies.

• Net to the family: Approximately $15,000 of pre-tax business deduction converts to nearly $15,000 in the child's hands.

Children 18-20 and Children Over 21

The under-18 FICA exemption ends at age 18. For children 18+ employed by a parent's business:

• FUTA (federal unemployment) exemption continues until age 21.

• FICA applies normally.

• Federal and state income tax apply normally (subject to standard deduction).

For S-corp and C-corp employers, FICA always applies regardless of age.

Roth IRA Contributions for Children

Children with earned income can contribute to a Roth IRA up to the lesser of $7,000 or their earned income (2025). For a child with $7,000 of earned income from family employment:

• Contribute $7,000 to a Roth IRA.

• At a 10% annualized return over 50 years (until age 65), the $7,000 grows to approximately $821,000 — entirely tax-free.

• Contributing $7,000 every year from age 12 to 22 (11 years), the cumulative balance at age 65 exceeds $4 million — tax-free.

The Roth IRA also has unique advantages for young account holders:

• Contributions can be withdrawn at any time without tax or penalty.

• First $10,000 of earnings can be withdrawn tax-free for first-time home purchase.

• Up to $10,000 of earnings can be withdrawn for qualified higher education expenses.

• Roth IRA balances are NOT counted in FAFSA for college financial aid (parental retirement assets are excluded).

Section 127 Educational Assistance Programs

Beyond direct wages, businesses can establish §127 educational assistance programs providing up to $5,250 per year of tax-free educational assistance per employee. For employed children pursuing education:

• Tuition, books, and required educational fees can be paid by the business.

• Tax-free to the child up to the $5,250 annual limit.

• Deductible to the business as an ordinary expense.

• Available for both undergraduate and graduate education.

• Recently expanded to include qualified student loan repayments.

Documentation Requirements

For any IRS examination of family employment arrangements, documentation should include:

• Written job description outlining the child's duties and responsibilities.

• Time records documenting hours worked and tasks performed.

• Pay stubs showing regular payment intervals (not lump-sum year-end "salary").

• W-2 issued to the child for the year.

• Employment tax filings (Form 941 quarterly or 944 annually) showing the child as an employee.

• Compensation analysis showing the wages are reasonable for similar services.

• Proof of payment via separate check or ACH transfer to the child's bank account.

Age-Appropriate Job Examples

Age-appropriate tasks that have been accepted in IRS examinations:

• Ages 7-12: Modeling for marketing materials, simple administrative tasks (organizing supplies, basic data entry under supervision), running errands.

• Ages 13-15: Social media content creation, photography, video editing, customer outreach via approved channels, inventory management.

• Ages 16-18: Bookkeeping support, scheduling, customer service, web development, content writing, more complex marketing tasks.

• Ages 18+: Full range of business activities consistent with skills and experience.

The Grandparent Application

Grandparents who own businesses can also employ grandchildren — but the under-18 FICA exemption does NOT extend to grandchild employment by a grandparent (only parent-employer relationships qualify). The federal income tax sheltering through the standard deduction still applies.

For grandparents seeking to transfer wealth to grandchildren tax-efficiently, family employment is one of several available strategies (others include 529 plan funding, annual exclusion gifts, and direct Roth IRA gifts of earned income from grandparent-funded employment).

Wealth Transfer Implications

Beyond current-year tax savings, family employment compounds across decades:

• Building Roth IRA balances in the child's name from earliest possible age.

• Funding 529 plans from the child's earned income.

• Establishing financial responsibility through real work and earned income.

• Reducing parents' future estate by shifting income to lower-tax-bracket children.

• Creating discussion opportunities for financial education.

Common Mistakes

• Paying children for fictional work (entire deduction disallowed on audit).

• Paying children disproportionate to actual services rendered.

• Failing to issue W-2s and run proper payroll.

• Treating the under-18 FICA exemption as available in S-corp employment (not allowed).

• Not establishing the Roth IRA contribution as soon as the child has earned income.

• Inadequate documentation of the work performed and the reasonableness of compensation.

• Family employment in service-business S-corps creating SSTB classification complications.

Bottom Line

Family employment is one of the most powerful intergenerational wealth-building strategies in the U.S. tax code. Done properly — with real work, reasonable wages, proper documentation, and immediate Roth IRA funding — it converts current personal expenses into deductible business expenses while building tax-free wealth that compounds for 50+ years. For business owners with children or grandchildren old enough to perform meaningful work, this strategy should be implemented as early as possible to maximize the multi-decade compounding effect.