You’re smart to be saving money for your children’s or grandchildren’s future. You can be even smarter. By paying a little attention to which assets you put in each family member’s name during Estate Planning, you can use the tax law to dramatically reduce the family’s tax bite on this money.
The kiddie tax allows significant tax savings on the investment income earned by a minor, such as a child or grandchild. But the savings disappear when income passes a certain level, and some tax benefits disappear altogether for money saved in a minor’s name.
When a child is under age 14, the first $750 of investment income is tax free. The next $750 is taxed at the 15% rate. (These amounts are indexed for inflation each year.) Investment income above $1,500 is taxed at the parents’ highest marginal tax rate. That could mean the tax rate jumps from 15% to 39.6% when a child’s investment income passes $1,500, and the tax shelter of shifting investment assets to a minor child’s name disappears.
Once the minor reaches age 14, the Kiddie Tax doesn’t apply. All investment income is taxed at the child’s tax rate.
Parents can elect to include the child’s investment income on their own tax returns. This saves the expense of preparing a separate return for the child. But it has some shortcomings and usually isn’t the best strategy.
Obviously the lower tax bracket creates an incentive to place some investment assets in the name of a child or grandchild.
One smart tax strategy is to put in the child’s name some safe income-producing assets to shelter that income from taxes. If you put $10,000 into Vanguard GNMA, you’ll get a yield of about 6.7%. In the minor’s name, that will generate $670 of interest income that is tax-free. To get the maximum Kiddie Tax break, you need to put over $22,000 in the child’s name. But the income will compound and increase each year, so you want to put in an amount that will grow into the Kiddie Tax limit around age 14. A gift of $10,000 to $15,000 is about right for a four-year-old.
Another option is to give the maximum you can afford to the child but have it invested so that it doesn’t pay much income. Invest it in stocks that don’t pay dividends or in mutual funds with reliably low distributions, such as most index funds. Then there will be little or no income to be taxed for years.
You can sell these investments and switch to conservative income-paying investments when the child turns 14. Then capital gains taxes will be due, but probably at the child’s 10% rate. In addition, a little-known feature of capital gains taxes takes effect in 2001. It provides that the capital gains tax is cut in half for investments held for five years or more. (See the August 2000 issue for details or check the tax archive on the web site.)
But here’s a reason why you might not want to put the growth assets in the child’s name. While income above $1,500 is taxed at the parents’ top rate, losses never can be used by the parents. They belong only to the child. Growth assets are likely to experience periodic losses, even when they turn out to be great long-term investments. If you or the child’s parents own the growth assets, during those loss periods you can sell the assets, and use the losses to offset some gains or other income. After waiting more than 31 days, you can repurchase the assets and wait for the compounded growth to resume.
You lose this ability to use tax losses when the growth assets are in the minor’s name. You still can sell the loss assets from the child’s account. If the child has little or no income to shelter with the losses, the losses can be carried forward to future years. When most of the assets are sold to pay for college, the accumulated losses might ensure that the gains are tax free. But that’s not much of an advantage when the child is age 14 or older (so the Kiddie Tax no longer applies) and is in the lowest tax bracket. The losses are much more valuable when they are used against the higher-taxed income of the child’s parents or grandparents.
When you have diversified assets in taxable accounts and are saving for a child’s or grandchild’s education, use the Kiddie Tax to your advantage. Here are some guidelines:
Put $10,000 to $20,000 in an account for the child. Vanguard GNMA is a good investment for this account. The amount you should put in depends on the child’s age. The younger the child, the lower the amount.
Keep growth assets that are designated for the grandchild in your account or the parent’s account. Tax losses can be managed each year and used against higher-bracket income.
For gifts of more than $20,000, put the money in a trust instead of the convenient Uniform Gift to Minors Act accounts. In most states, once a child turns 18, he or she gets unrestricted legal access to the money. It can be spent on whatever the child wants and there is nothing you or the parents can do about it. To protect against youthful bad judgment or a teenager gone astray, larger amounts should be kept in trusts for the child’s benefit.
If an UGMA does get to be large and you are concerned about what the child might do with it, consider spending it down before the child turns 18. The money can be spent only for the child’s benefit. Rules vary from state to state. But you might decide it is better to use the money to give the child a television, computer, car, trip to Europe, and some other goodies rather than leave it in place until age 18.
If you will sell some stocks or mutual funds at a profit to pay for college expenses, first transfer the investments to the child’s name. Then have the assets sold. Since the child is age 14 or older at this point, the child’s tax rate will apply to the gains. But here again the money will be in the child’s name, and you take the risk it will be diverted before reaching the college treasurer.
Another option for larger sums is to bypass trusts and UGMAs altogether. Consider creating an account for the child in a state’s 529 tax-advantaged college savings plan. I covered these in detail in the March 2000 and January 2001 issues. Check the issues or the archive on the web site.
Another reason not to transfer a large amount to a child or grandchild – in either a trust or an UGMA – is the financial aid rules colleges apply. I’ll discuss in an upcoming issue how to use these rules to your advantage, whether you are a parent or a grandparent. The financial aid rules can be valuable tools, even if you believe your family is too wealthy for financial aid.