The New Kiddie Tax: How It Might Change Gift Giving

Last update on: Aug 10 2020
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Before making gifts to children and grandchildren, carefully consider the new kiddie tax.

The Tax Cuts and Jobs Act greatly simplified the Kiddie Tax. The tax was imposed in the Tax Reform Act of 1986 on unearned (investment) income of children. The idea was to end income splitting. That was the practice of high-income earners shifting some of their income to relatives in lower tax brackets, usually by giving investment assets to children directly or through trusts. Initially, only children under age 14 were subject to the tax. The scope was increased over the years. Now, it applies to most children under 18 and full-time college students under 24 who don’t pay for more than half of their support.

The original Kiddie Tax had the children paying taxes on their investment income at their parents’ highest tax rate. It required a separate form and some complicated computations. It also required parents to share their tax information with their children.

Beginning in 2018, youngsters who are subject to the Kiddie Tax will pay tax on their unearned income using the same tax tables as trusts. That greatly simplifies computation of the tax and means parents don’t have to share their data. But the new rules mean many who are subject to the Kiddie Tax will pay higher taxes than they would have under the old rules.

For example, the maximum 20% capital gains tax is imposed on trusts when taxable income reaches $12,700. Last year, that rate wasn’t imposed on an individual until taxable income exceeded $400,000. Throughout the tax tables, tax rates are imposed on trusts at much lower income levels than for individuals.

But some children will pay lower income taxes under the new rules. When a child’s parents are in the top tax bracket and the child receives only a few thousand dollars of investment income, the income will be taxed at a lower rate under the new rules. The child won’t be in the top tax bracket.

The Kiddie Tax applies to all unearned income. That, of course, includes all types of investment income, but also includes distributions from traditional IRAs and 401(k)s and some Social Security survivor benefits.

A child subject to the Kiddie Tax receives a $1,050 standard deduction that makes that amount of unearned income tax free. The next $1,050 of unearned income is taxed at a lower rate, but tax advisors disagree on whether it is taxed at the child’s tax rate or using the trust tax tables. The rule is unclear until the IRS issues guidance.

This means the first $2,100 of unearned income earned by a child or grandchild is either untaxed or taxed at a low rate. Additional income will be taxed using the trust tax tables. So, parents and grandparents have to monitor a youngster’s unearned income sources carefully before giving additional income-producing investments or selling long-term capital assets held in the youngster’s name.

One strategy is to consider leaving a child who might be subject to the Kiddie Tax a Roth IRA instead of a traditional IRA.

Another strategy for grandparents might be to give appreciated property to the parents instead of to the grandchildren. Suppose the grandparents are in the top tax bracket but the parents are in a lower bracket. The grandparents have an investment asset with a significant long-term capital gain. They want to sell the asset to help pay for the grandchild’s education or other needs.

The grandparents would owe the 20% capital gains rate if they sold the asset, and the grandchild also would owe the 20% rate if the amount of the gain was significant or the grandchild already has enough unearned income to be in the top trust tax bracket. But the parents might owe only a 15% (or lower) rate if they were given the property and sold it.

The irony is that under the new rules, top-bracket parents or grandparents probably can transfer more money to youngsters before triggering a higher tax than lower-bracket adults can. The top tax rate of 37% begins at $600,000 of taxable income for married taxpayers filing jointly and at $12,500 for trusts. That means a top-bracket family can transfer up to $12,500 of gains or other unearned income to a child or grandchild before the 37% rate is triggered on the child. But an adult in a lower tax bracket has to transfer less than $12,500 before the child begins paying a higher rate than the adult would pay

The new Kiddie Tax makes computing the tax easier, but it can make planning more complicated for many families.

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