Have you ever heard the words “kiddie tax” before but didn’t fully understand what that meant? Today I’m going to explain to you what kiddie tax means, how it came into existence, and how it has changed with the passing of the Tax Cuts and Jobs Act.
Kidde tax was initially implemented in 1986 as part of the Tax Reform Act. Its primary purpose was to prevent parents from transferring investment assets into their children’s name to escape taxation. By placing the assets into the name of their children, parents could shelter income that was ordinarily taxed at their higher tax rate and have it taxed at the lower tax rate of their child.
Once Congress caught onto this strategy, the kiddie tax rules came into effect. The rules have changed slightly over the years, with the most dramatic change resulting from the Tax Cuts and Jobs Act (effective for the 2018 tax year).
Kiddie tax applies to:
Children under the age of 18
A child who is 18 at the end of the year, and their earned income is less than 50% of cost of their support
Full-time students between the ages of 18-24, also with earned income less than 50% of cost of their support
Once the child reaches 24 years of age, the kiddie tax rules will no longer apply. Even if the child remains a full-time student at age 24 or older, they will no be subject to kiddie tax.
Kiddie tax was established to tax the child’s unearned income (investment income and other income not related to employment) at the parent’s marginal tax rate. This includes income from interest, dividends, capital gains, inherited IRA and even Social Security survivor’s benefits received.
Before the Tax Cuts and Jobs Act, the kiddie tax only applied when the child’s unearned income exceeded $2,100 for the year. Under both the old and the new law, the first $1,050 of the child’s income will be tax-free and the next $1,050 of income will be taxed at 10%. Under the old law, the unearned income in excess of $2,100 was taxed at the parent’s marginal tax rate, which typically was higher than the child’s tax rate. Now, under the new law, the child’s unearned income in excess of $2,100 will now be taxed at the same rate as trusts and estates.
Trusts and estates reach the top federal tax rate of 37% once income exceeds $12,500. For married filing joint returns, the top federal tax rate will be reached only when income exceeds $600,000. Children with substantial investment income will take a huge tax hit, especially when their parents are in a lower tax bracket.
There are ways to limit your kiddie tax exposure or avoid it altogether. One strategy is to invest the child’s assets in tax-exempt municipal bonds or US Savings Bonds. Interest on municipal bonds are not subject to federal income tax. US Savings Bonds interest can be deferred until they reach maturity. You can elect to report the interest each year on the accrual method. This is a great idea for children under the $2,100 kiddie tax threshold, as it allows you to take advantage of the child’s lower tax rate and standard deduction.
Investing in growth stocks will also reduce the amount of kiddie tax your child will be subject to. These tend to be riskier investments, but they offer a higher rate of return when held long-term. By holding these assets until the child is no longer to kiddie tax, they can take advantage of lower capital gains tax rates when the assets are sold (0% in 2018 if taxable income is $38,600 or less).
Parents and grandparents may also choose to fund a child’s Sec 529 plan. These qualified tuition plans can now be used for up to $10,000 per year of qualifying K-12 expenses as well as eligible higher-education expenses. Some state plans may offer tax incentives for contributing to these plans, so be sure to do your homework being starting a plan.
Lastly, employing your child can be a great way to avoid kiddie tax and get a business tax deduction. With the increased standard deduction of $12,000 in 2018, your business can pay $12,000 to your child which will fully offset the standard deduction, resulting in $0 taxable income. Further, you can pay your child $17,500 and have them fund a traditional IRA for $5,500, leaving $12,000 of income which will be reduced by the standard deduction to $0. That’s a huge tax savings for your business and for your child!
As always, feel free to email your tax or financial planning questions to me and I would be happy to help you find the right answer.