Raising children who understand the value of money gives them an advantage. So, that means your kids need to know about taxes. Of course, receiving a check at their first job for much less than the $15 per hour stated on the employment agreement is one way to find out.
Instead of believing that they’ve been robbed by their employer (or the government), by learning early on why taxes are deducted from their checks, they’ll understand that some of the taxes taken out pay for Social Security and Medicare when they’re no longer able to work.
They’ll also find out that federal and state taxes pay for things like the police and fire departments in the town where your family lives, as well as roads and bridges in addition to national defense and parks. Maybe even more important to many kids today, the fiber optic infrastructure that allows them to stay online all day!
As a taxpayer, of course, you well know that taxes can be complicated. While you know that you don’t need to burden your five-year-old with the difference between marginal income tax rates and capital gains rates, you might not be sure what your kids need to know and when.
As always, you know your children best, and you might want to let them in on some of these topics earlier or later than suggested, depending on personalities and experience. The ranges are pretty broad, though. Take the opportunity to make sure they’re clear on the foundations before you start teaching them more advanced topics.
Children ages 5-10 need to understand tax basics
Even in elementary school, your kids can absorb some fundamental and easy lessons about taxes. It’s probably easiest to start while you’re shopping at the grocery or toy store. Find an item whose price is easy to understand, like $1 or $5 or $10. (Good luck in some of the stores, which for behavioral finance reasons, charge $4.99 or $9.99 instead! But that’s a lesson for later.)
Run the item(s) through checkout separately, so it’s clear on the receipt how much tax you paid. Point out that while the price was $5, the amount that came out of your pocket was slightly more than that.
They’ll want to know where the money goes. At this age, there’s no need to get very specific. Your kids only need a high-level overview; that money goes to the government to fund things like parks, police, and schools. No need to get political here either; just the basic facts will do.
Middle school/junior high, ages 11-13 need to understand taxes in relation to their paycheck
At this point, your kids will be familiar with sales taxes, having seen you shop. Maybe they’ve been able to shop themselves.
They’re old enough to begin learning about other taxes, such as income tax, property tax, and Social Security/FICA. Show them your pay stub and discuss the various amounts that have been deducted and why. If you have Social Security statements, you can demonstrate where the money goes later on in life.
Let them know what the deductions for Medicare and Social Security pay for. You can also explain the federal, state, and potentially local taxes. They should have a basic understanding of the US government from school and know that the federal government is in charge of some things, and state and local governments run others. Taxes at every level support all these different branches of government.
Although you’ll explain the deductions from your paycheck to them in some detail, that’s not the central concept they need to know. The big lesson here is that the money they earned according to the stated pay rate is not what shows up in the paycheck.
Show them the difference between the stated rate and what gets deposited into your account. Of course, not all deductions will be taxes since you likely have health care and retirement contributions taken out as well. Talk to them about the importance of budgeting with the net amount after taxes and other deductions, not the gross income.
Show them your property tax bill as well. Property owners fund local improvements and projects, so they need to understand where the money goes.
Teens 14 and over need to understand how to file their taxes
At this age, your kids are probably paying taxes in some shape or form already. They’re paying sales tax when they shop, and if they have jobs, they’ll also be paying income tax. They know the reality of paying taxes, especially if you’ve been educating them along the way.
If they do have part-time (or other) jobs, show them how to keep their documents organized for tax time. Let your kids know about the importance of W-2s and why they need to keep track. They should do their income taxes (with your guidance, of course) during this time.
There are plenty of online software applications to use, which makes it easy. My dad made me do my taxes when I was in high school, and back then, we had to use paper forms and read the instructions.
Doing their taxes each year helps your children understand the basic calculations and the importance of tax deductions. They’ll also be in the habit of doing their taxes annually, so they won’t need to worry about IRS fines and fees later on.
If they don’t have their own jobs, they can sit with you while you do your taxes online or go to the CPA with you.
When your kids start asking why so much money goes to taxes, discuss how Congress sets the rates. You can also show them that income tax rates change over time. For example, income tax rates on high earners are currently significantly lower than when the government built the interstate highway network across America and other big infrastructure projects in the middle of the last century.
If they’ve been investing, or you’ve been investing on their behalf, introduce capital gains tax. Explain how they only pay it when investments are sold. Let them know about capital losses, which can reduce the amount of capital gains they’ll need to pay taxes on.
Understanding income and capital gains taxes is an excellent segue into the importance of tax-deferred accounts. You know your children will need a significant amount of assets in the future and the need to start saving early to take advantage of compound returns. Show them what a difference not paying income and capital gains taxes on the money they accumulate in these accounts makes down the road.
If you’ve been saving for their future in college 529 accounts, you have another chance to showcase the importance of deferred or tax-free (for qualified expenses) money. Depending on when you started funding the accounts, you can also demonstrate the power of compounding over time.
There are many opportunities to teach your kids about taxes in an age-appropriate way. It’s critical for them to understand the difference between gross and after-tax income to know how to budget appropriately. Tax season is an excellent time to demonstrate to your older kids why they need to understand IRS rules and regs.
If you’d like to talk to us about investments for your kids, please feel free to give us a call at 619.255.9554 or email us to set up an appointment.
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