Beating the Summertime (Tax) Blues

05/31/2012 9:00 am EST

Focus: TAXES

Terry Savage

Author, The Savage Truth on Money

Your child’s first W-4 is cause for celebration, but also a grim introduction to the ever-increasing tax bill he or she will have to pay over the years. MoneyShow personal finance expert Terry Savage explains what to look for and shares a couple of tips to make this event more bearable.

If your son or daughter manages to get a job this summer, count your family as among the lucky few. Your college age student will be excited…until he or she receives that first paycheck and asks: “What happened to all the money?”

Welcome to real life, where money earned is shared with the government. It may be a rude awakening for your child.

The first thing he will be asked to do is fill out IRS form W-4, the Employee’s Withholding Allowance Certificate. That’s how the employer will figure out how much to withhold from his paycheck for Federal income taxes. That will be the first shock, because the amount withheld will be based on the pay level as if he were a full-time worker.

But since he will only work for a few months, he probably won’t reach the income level necessary to pay taxes: $5,950. So next April, he can file for a tax refund. And yes, in the meantime, the government gets the use of his money!

And don’t forget, if your state has an income tax, there will be another big cut from his paycheck. Since you don’t get an “itemized deduction” on your state income taxes as you do with the Federal government, he probably won’t get this money back.

He will also notice a deduction for FICA—the “payroll tax,” or as it is commonly known, the Social Security tax. The threshold for paying FICA is $400, and this is money he won’t get back until retirement. Maybe.

Tell him that FICA stands for Federal Insurance Contributions Act—so he’s really making a “contribution” (not voluntary) to his future retirement in the event that Social Security is still around. Actually, he’s making a contribution to your retirement!

Then he can spend—or save—whatever is left after all those deductions.

It’s likely that he will qualify for a Federal tax refund next year. If he is in college and under age 24, as a full-time student, he can be claimed as a dependent on your return, giving you a deduction. Even so, next April he must file his own return to claim the tax refund.

He won’t be able to claim his personal exemption because he is a dependent on your return, but he will get the standard deduction of $5,950 for 2012. Thus, if he earned less than that amount, he will get back all the withholding taxes he paid in because he has zero tax liability.

However, if your son is no longer a full-time student for at least five months of the year, and earns more than $3,800, you can no longer claim him as a dependent. Then he would get both the individual exemption and the standard deduction, resulting in a larger tax refund to him—and a bigger tax bill to you!

Either way, he will learn how to file his own tax return. And surely he’ll do it in January, because he will be anxious to get the money back!

Here’s one more creative tax idea. Even if he spends all the money he makes, you might want to create a Roth IRA for him, where you can invest the amount he earned—up to $5,000—to grow tax-free for his eventual retirement. Or you could create an incentive and match dollar for dollar, or two for one, every penny he saves in the Roth IRA.

Open an account at any mutual fund company and invest it in the stock market. Over the long run, it will grow in value, and serve as an encouragement for future savings. That is truly a gift that will grow in value.

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