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How to Navigate the “Kiddie Tax”
Shifting assets and income to your children and grandchildren can provide many benefits, including tax benefits.
That’s why Congress set up hurdles to keep you from enjoying all the potential tax benefits.
When planning gifts of investments to your loved ones, be aware of the "Kiddie Tax." This tax was created in 1986 to reduce a strategy known as income splitting.
That’s when someone in a high tax bracket transfers income to a loved one in a lower tax bracket, usually by giving an investment asset.
The loved one receives investment income, or sells the asset for a capital gain, and pays taxes at a lower rate. The money stays in the family, but there’s more of it left after taxes.
The basic rule of the "Kiddie Tax" is that the unearned (investment) income of a youngster is taxed at the parents’ highest marginal tax rate.
As with the rest of the tax code, there’s a lot more to it than the general rule.
At first, the "Kiddie Tax" applied only to children under age 14. It was expanded to cover almost all children under age 18, and full-time students up to age 24 who can be claimed as dependents on a parent’s tax return.
There are other situations when it applies. Read the instructions for Form 8615 carefully. (Yes, the "Kiddie Tax" has its own tax form.)
The first $1,050 of the youngster’s investment income is exempt from the "Kiddie Tax". The exemption is indexed for inflation, so it rises gradually over time.
Also, remember the tax applies only to unearned income, such as interest, dividends, capital gains, royalties, and the like. Earned income, such as from jobs, isn’t affected.
In addition, the next $1,050 of investment income (also indexed for inflation) is taxed at the youngster’s tax rate. Note that only the amount of investment income matters, not how the child acquired the investment assets.
So, only after the child or grandchild has more than $2,100 of investment income in 2016 does the "Kiddie Tax" kick in, and Form 8615 doesn’t have to be filed until the youngster’s unearned income exceeds $2,100.
At current interest rates and dividend yields, a youngster can have around $100,000 invested in his or her own name in 10-year treasury bonds or the S&P 500 without triggering the "Kiddie Tax."
But a smaller portfolio will trigger the tax if it earns a higher yield or there are capital gains exceeding $2,100.
Only investment income that is otherwise taxable faces the "Kiddie Tax." The tax can be avoided if, for example, the youngster owns mutual funds that don’t make significant distributions, or stocks that don’t pay much in dividends, and the child doesn’t sell them.
Tax-exempt bonds and mutual funds also avoid the "Kiddie Tax," regardless of how much income they generate.
On the other hand, events outside your control or expectations can trigger the "Kiddie Tax."
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A mutual fund that’s had low distributions for years might have a large gain or other event that causes a large distribution for the year, giving you little time to plan for it.
Or a stock in the youngster’s portfolio might be the subject of a merger or other corporate change that is taxable to shareholders.
When more than one child in a family is subject to the "Kiddie Tax," all the children’s investment income subject to the tax is added to the parent’s income to determine the tax rate.
That means, in a family that distributed a lot of income-generating assets to the children, the additional investment income could be high enough to push them into the next tax bracket and trigger an even higher "Kiddie Tax." It also has the potential to trigger the 3.8% net investment income tax.
The normal filing process is for an income tax return to be filed for the youngster with Form 8615 attached.
When the child is a minor, that often isn’t an issue. The parents prepare or have prepared the tax return and either sign it on the child’s behalf or have the child sign it.
Significant information from the parents’ return must be included on Form 8615. That’s an issue for some parents as children become older, especially for those up to age 24 who are full-time students. The parents might not want to share that much detail about their finances with their children.
For those and other cases, there’s an option for the parents simply to include the investment income of the children on their own tax returns. This can be done when a child’s investment income is less than $10,000.
Some people want to avoid the complications of the "Kiddie Tax," and have more control over the assets, by having a trust hold investments that benefit the child.
Carefully consider all the implications of a trust. You need substantial assets to justify the cost of the trust. Also, it takes careful distribution management to minimize family income taxes.
When investment income is accumulated in the trust, the trust vaults into the top tax bracket when its taxable income is only $12,400. When income is distributed to the child, it retains the same character it had in the trust.
So, if a trust distributes investment income, it is reported as investment income on the child’s tax return and it could still trigger the "Kiddie Tax."
You didn’t think the government was going to make it easy for you, did you?
To a better retirement,
Editor, Retirement Watch Weekly
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Why Tax Reform is Stalled
by Bob Carlson
Editor, Retirement Watch
This article highlights one of the key disagreements that is preventing agreement on tax reform. It says economists and many in Congress want to allow full expensing of equipment purchases, instead of requiring businesses to depreciate it over years. Businesses say they prefer lower tax rates. I’ve seen studies of how businesses respond to incentives such as the accelerated depreciation allowed after the financial crisis. They don’t increase capital investment much. Taxes are but one small factor in a capital investment decision.
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About Bob Carlson:
Robert C. Carlson is the author of the books The New Rules of Retirement and Retirement Tax Guide, editor and investment director of the popular retirement newsletter, Retirement Watch, and editor of the free weekly e-letter, Retirement Watch Weekly. Bob is a frequent speaker at investment conferences around the country, and you can also hear Bob as a featured guest on nationally-syndicated radio shows, such as The Retirement Hour, Dateline Washington, Family News in Focus, The Michael Reagan Show, Money Matters and The Stock Doctor.
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