Years ago, to prevent parents from transferring their investment accounts into their children’s name to avoid taxes, Congress created what is referred to as the kiddie tax. This counteracted the strategy of taking income from the parents’ higher tax bracket and shifting it to their children’s lower tax bracket.
The kiddie tax plugged that tax loophole by taxing the child’s unearned income (income not from working) at the parent’s top marginal rate.
That has all changed under the new tax reform. Beginning in 2018, children’s tax rates are no longer based upon their parents’ top marginal rates. Congress streamlined the kiddie tax by taxing a child’s unearned income by the capital gain and ordinary income rates that apply to trusts and estates. Thus, the child’s tax is unaffected by the parent’s tax situation or the unearned income of any siblings, while the earned income is taxed using the single tax rates.
Although this will greatly simplify the preparation of a child’s return, there will be losers and winners. One of the big winners will be a child who is employed. Since earned income is taxed at single rates, a working child will benefit from the new higher standard deduction allowing them to make up to $12,000, instead of the previous $6,350 of earned income without any tax.
On the other hand, for those with substantial unearned (investment) income, that income will no longer be subject to the parent’s top tax bracket but instead will be taxed at the rates for estates and trusts, which for 2018 hit 37% at a taxable income of $12,500.
The losers will be children with substantial investment income, which will be taxed at the trust rates, especially children whose parents are in a low tax bracket. Under the old law, a child’s unearned income was taxed at the parents’ top tax bracket, which now may be lower than the fiduciary tax rates.
The kiddie tax applies to children under the age of 18, a child age 18 at the end of the year with earned income less than one half the cost of their support, and full-time students between the ages of 18 and 24, also with earned income less than one half the cost of their support.
Parents with children might consider some of the following investment strategies for their children to avoid the kiddie tax issues:
- U.S savings bonds – Invest in U.S. savings bonds. Not the best return on investment, but interest can be deferred until the bonds are cashed.
- Tax-deferred annuities – Invest in tax-deferred annuities. The income can be deferred until the annuity is surrendered.
- Municipal bonds – Invest in municipal bonds. They generally produce tax-free interest income (which may be taxable to the state).
- Growth stocks – Invest in stocks that focus more on capital appreciation than current income.
- Unimproved real estate – Invest in unimproved real estate, which provides appreciation without current income.
- Family employment – If the family has a business, that family business could employ the child. The child’s earned income is not subject to kiddie tax and will generate a deduction for the family business (assuming the wages are reasonable for the work actually performed). The child’s earned income can offset the standard deduction for a dependent, and the excess income will be taxed at the child’s rate (not the parent’s). In addition, the child would also qualify for an IRA, which provides an additional income shelter.
- Individual IRA Account – If a child has investment income and earned income, the earned income can be used as a basis for depositing investment funds into an IRA account. Funding an IRA at an early age is perhaps one of the most underused family wealth-building strategies. Generally, a Roth IRA would be preferable for a child with little or no tax liability.
- Sec. 529 Qualified Tuition Plans – If parents, grandparents, or others want to transfer money to a child, depositing the funds into a Sec. 529 plan will allow the earnings to accumulate tax-deferred, and if used for qualified college expenses, the earnings are withdrawn tax-free.
If you have questions or would like to schedule an appointment to discuss a child’s tax situation and options, please give us a call.