Shifting assets and income to your children and grandchildren can provide many benefits, including tax benefits must be past of your estate planning. 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 and you must include these considerations in your estate planning.
At first the Kiddie Tax applied only to children under age 14. It was expanded to cover almost all children younger than age 18 and also to 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 carefully the instructions for Form 8615. (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, regard-less of how much income they generate.
On the other hand, events outside your control or expectations can trigger the Kiddie Tax. 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 for estate planning. 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 estate planning 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 use estate planning to avoid the complications of the Kiddie Tax and also 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 still could trigger the Kiddie Tax. While there are good reasons to consider having the assets held in trust for the child, reducing income taxes might not be among them.
RW April 2016.