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The Hows and Whys of Taxing Your Child’s Allowance Money
A few years ago, when I was using TurboTax to prepare our family’s income tax return, my youngest child hopped up on my lap. He had the insatiable curiosity that only a five-year-old can possess, and thus he immediately began peppering me with questions. What are you doing? What are income taxes? Why do you have to pay that money?
As I explained to him the basics of income taxes, I realized that the best way to teach the lesson of taxes to him was to run a little experiment on his allowance, along with his older siblings. What could I actually teach them about taxes that would feel like a learning experience and not like punishment?
This is a question many parents ask themselves when teaching their children about money basics. Giving a child an allowance is a pretty standard financial teaching tool, but how do taxes fit into this?
To be clear, this is about “taxing” your child’s allowance, in the sense that you’re choosing to withhold a portion of their allowance for the purposes of teaching your child a practical lesson about taxes. This does not have any actual taxable consequence. Let’s be abundantly clear: there are no federal tax consequences for giving your minor child unearned income in the form of an allowance.
Should you give your child an allowance at all?
The first question that many parents ask is whether they should give their children an allowance at all. If so, should that allowance be tied to household chores?
A study by Rona Abramovitch, Jonathan Freedman, and Patricia Pliner in the Journal of Economic Psychology sought to answer that question. They concluded that children who received allowances demonstrated a better mastery of pricing knowledge, meaning that they had a much more developed sense of the prices of items and how far their money would go.
What about tying allowances to chores? Joe Pinsker in The Atlantic expressed doubt about this approach. “A range of experts I consulted expressed concern that tying allowance very closely to chores, whatever its apparent short-term effectiveness, can send kids unintentionally counterproductive messages about family, community, and personal responsibility. In fact, the way chores work in many households worldwide points to another way, in which kids get involved earlier, feel better about their contributions, and don’t need money as an enticement.”
Pinsker goes on to discuss the matter with several experts in various fields, including child psychology and finance and seems to conclude that a small allowance should be given to teach financial lessons, but not as an exchange for expected household chores. This is the approach we have used for our children’s allowances for many years.
Should you tax your child’s allowance?
What about taxing your child’s allowance? In this case, “taxing” means the process of taking money out of their allowance directly to be put aside for some later purpose.
Clearly, many parents put money aside for long-term objectives for their children. They make contributions to 529 college savings plans. They save up money for musical instruments or for other educational opportunities. In these situations, you’re taking money that could have been given to them to spend and instead of putting it aside for a long-term goal.
The most significant difference is in how you’re explaining this to the children. Are you describing that 529 contribution to them as part of their allowance that you’re taxing? Are you doing it silently? Or are you describing it in some other way?
In short, rather than wondering whether you should tax your children’s allowance, which you’re already partly doing by putting aside money for big future expenses they’ll have, you should be asking what lesson they could learn from such a strategy. What could they learn if you approached this a little differently?
The lessons that taxing allowances teaches
An important part of deciding whether to tax a child’s allowance is to establish what lessons you’re wanting to teach your child about taxes. Start by considering what income taxes actually are: they’re a system by which the government takes a portion of your income to provide goods and services used by everyone.
What is income tax?
As noted above, income taxes are money that is taken from people’s paychecks to pay for goods and services used by everyone. A good way to approach this lesson would be to use the money you’re taxing out of a child’s allowance for something that they clearly understand and appreciate, so they connect how their money is a part in paying for something big but understandable.
What happens if you don’t pay income taxes?
For most workers, taxes are taken directly out of their paycheck, but if you don’t pay your taxes, the IRS will hit you with financial and, eventually, legal penalties. The important lesson here is to simply make it automatic by “taking it out of their paycheck.” Simply tell them that you’re taking out a certain percentage for “taxes” when you pay them.
What are taxes used for?
Again, tax dollars are used for goods and services used by everyone, and everyone pays for it through their tax contributions. If this is a lesson you which to teach, connect the money that’s “taxed” from their allowance for a good or service that’s meaningful to them, while also considering that the shared goal is meaningful or useful for others. You can even dive into a discussion of what real income tax money is actually used for. This makes for great family dinner table conversation.
Our experiment in taxing children’s allowances
So, we sat down together and had a family meeting centered around a single question: what improvements would you like to see around our house that we will all contribute to paying for? We considered several options – a basketball court, a room for taekwondo practice, a swimming pool, and a Nintendo Switch among them – before eliminating the most expensive ones, then we put it to a vote: which option did we want the most? Our family chose the swimming pool option. We decided to get a much nicer pool than the typical “kiddie pool” we may have selected in other summers.
Before we looked at the pool options, however, we talked about how we would pay for this swimming pool. Each week, we would take 20% out of each child’s allowance, along with $10 from each parents’ paycheck, and put it toward our swimming pool project. This money wouldn’t be given by choice to the project — if the income tax plan were to happen, it would mean that the money would be taken from now on. They agreed to the plan.
We reduced the amount paid out of each child’s allowance by 20% during the period of this experiment. Each time we paid an allowance, we reminded them that we were taxing a portion of their allowance for the swimming pool. We kept track of these savings on a piece of paper that we kept near their piggy banks.
We had a dollar goal, and as we approached it, we made sure the children were clear on how their allowance was a part of that big expense, and eventually, we could afford the pool that all of us paid for!
Afterward, our children seemed to have a deeper innate sense of what we wanted them to learn about income taxes: that it’s money that comes out of everyone’s income to pay for goods and services we all share. The money we kept out of their allowance helped buy the pool we all used, just as the money kept out of mom and dad’s paychecks helps pay for the roads and the fire department.
Although this lesson was learned, we decided as a family to discontinue the experiment and restore allowances to their previous level. Still, we wound up with a much nicer pool than we would have had in previous years
Three keys for successfully taxing your children’s allowance
If you’re going to attempt such an experiment, here are three keys for making it successful (beyond understanding the basics of income taxes yourself).
- Communicate clearly what’s happening at each stage. Whenever you pay your children, remind them of the tax and how it’s contributing to the overall goal so that it doesn’t just become a smaller allowance.
- Let the children be involved in selecting the purpose of the tax revenue. This plan hits home much better if they’re involved in the selection of the use of the tax revenue. If you just take the money for some use they’re not involved with, it’s less meaningful. Have discussions about a few options, then put it to a vote, which becomes a good lesson in taxes and politics.
- Don’t make the goal too big. Selecting a goal that’s too large moves the goal beyond what’s meaningful for your child. Choose something that you can make meaningful progress toward each week. A goal that’s achievable in a number of months is a good choice.
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