The Tax Reform Act of 1986 first brought about the concept of taxation on the investment and unearned income for those individuals over thirteen and under seventeen years of age. It is commonly known as the “Kiddie Tax.” Originally the law only covered children over fourteen, as children under that age cannot legally work. This meant that any income of a child under fourteen was derived from dividends or interest from bonds. More recently, the age limits were revised to include children who hadn’t reached age nineteen by the close of the tax year, and full-time students under age twenty-four whose earned income was less than half of their own support, had at least one living parent, and didn’t file a joint return. In the original tax bill, this tax is imposed on children whose investment and unearned income was higher than the annual threshold. Under the old law, the first $1,050 of a child’s income is tax-free and the next $1,050 is taxed at 10%. Furthermore, any unearned income over the $2,100 was taxed at the parents’ rate if it was higher than that of the child. Earned income, like wages from a job, were still taxed at the child’s lesser rate. In other words, the earned income from a job and the unearned investment income up to $2,100, less the standard deduction, was taxed at the child’s rate. This encouraged parents and grandparents to make financial gifts to minors in the form of appreciated stock, assets from taxable estates, income transfers, and inherited IRAs.
During the introduction of the new Tax Cuts and Jobs Act of 2017 little was said about the rewrite of the Kiddie Tax rules. With these changes taxpayers will need to give pause in their strategies. Beginning in 2018 and continuing until at least through 2025, when the law sunsets, the taxable income attributable to the child’s earned income is taxed under the rates for a single individual, as before. However, the portion of the unearned income that is subject to tax, meaning the amount over $2,100, will now be taxed at the brackets applicable to trusts and estates. This does mean that calculating the Kiddie tax will become far simpler. Previously, parents and children would have to combine the income from all of the children, figure the parents’ tax rates and spread the tax between everyone. Now everyone’s earnings are separate. But with the use of the trust and estate brackets, there will be added complication in the form of a higher tax bracket for most. For example, the income from IRA distributions, interest and short-term gains is taxed at the rate of 37% when the estate and trust rates are applied (once it exceeds $12.500). By contrast, the married parents would only pay that rate on the portion of their income that exceeded $600,000. The top long-term capital gains rate of 20% kicks in at $12,700 for the child, but not until $479,000 for the parents.
Children of high earning parents may find themselves in a lower tax bracket, as high-income taxpayers could be taxed up to 39.6%. However, families of modest means will be hit harder, where the tax bracket is well under 37%. Additionally, the tax applies to all types of unearned income, including Social Security from survivor’s benefits, legal settlements, investment income, and inherited IRAs and 401Ks.
The new tax law changes will also affect the standard course of utilizing inherited IRAs and other investments for school funding. For example, a college student has parents in a fairly low-income tax bracket. The grandparents previously gifted the child stock to sell. For this example, the child pulls out funds for college, resulting in $200,000 of capital gains. Under last year’s taxes, the $200,000 would have been subject to his parents’ capital gains rate of 15%. Under the new law, the same gains are subject to 20%. Under this taxation difference, it would have been a better strategy to gift the stock to the parents and have them sell it for the lower bracket on the gains. Additionally, because by definition, a child must provide over half of their support from earned income to qualify as financially independent, this withdrawal of funds will not remove them from the Kiddie Tax effects. Many financial advisory firms are recommending that the safest tax strategy is to have the student borrow for college and then utilize the IRA withdrawals to pay back the loan(s) after they have turned 24.
Parents and grandparents wishing to gift investment wealth to their descendants will have to utilize a bit more strategy. Leaving a child a Roth IRA may present a better option, as these result in tax-free payouts that would not be subject to the Kiddie Tax. Naming children or grandchildren as beneficiaries on a Roth IRA and rolling the investment funds from a traditional pre-tax IRA to the Roth can be a good strategy. Traditionally, the grandparents will have a lower income tax bracket and can take the hit of the taxes on the pre-tax rollover. Make sure that you do not leave your IRAs subject to your estate. This will mean that the distribution to your beneficiaries will need to take place within five years and cannot be stretched over the life span of the beneficiary. Choosing investments wisely, is also a good strategy. With $2,100 of non-taxable and low tax rate dollars to work with, dividends from large investments can be relatively sheltered from tax. On the other hand, a taxable merger with large capital gains could result in a much higher Kiddie Tax. If the goal is to pay for education, funding a 529 college plan is a good way to give tax free assistance. Furthermore, the Tax Cut and Jobs Act allows for up to $100,000 a year of 529 money per child to be used for kindergarten through twelfth grade private-school costs tax-free, provided your state allows it. Gifts of low-basis stocks to a Uniform Transfers to Minors Act account is also still a sound strategy. Since the parents’ return is no longer involved, UTMA simpler now. Additionally, once UTMA held stocks are sold, the funds can be transferred into a 529 account.
Many people wait until year-end to make substantial gifts. With the complications added by the Tax Cuts and Jobs Act, now is a good time to start the process of determining the best possible ways in which to pass along your wealth. The best advice is to seek the aid of a tax professional to run numbers and find the best way to achieve your goals.