Joseph Femia, Senior Vice President
November 8th, 2018 | 11:13 AM
Despite its name, the “kiddie tax” is far from child’s play. And a recent change made by the Tax Cuts and Jobs Act (TCJA) puts some new adult teeth into the tax. Now, children with unearned income may find themselves in a higher tax bracket than their parents. At the same time, the TCJA creates new opportunities for family income shifting.
INCOME SHIFTING DISCOURAGED
At one time, parents could substantially reduce their families’ tax bills by transferring investments or other income-producing assets to their children in lower tax brackets. To discourage this strategy, Congress established the kiddie tax in 1986. The tax Essentially eliminated the advantages of income shifting by taxing all but a small portion of a child’s unearned income at his or her parents’ marginal rate.
When the kiddie tax was first enacted, it applied only to children under 14, but in 2007 Congress raised the age threshold to 19 (24 for full-time students). Note that the kiddie tax doesn’t apply to children who reach 19 (or 24, if applicable) by the last day of the tax year. In addition, the tax doesn’t apply to children who either 1) are married and file joint returns, or 2) are 18 or older and have earned income that exceeds half of their living expenses.
TAX BITE BIGGER
Starting in 2018, the kiddie tax applies according to the tax brackets for trusts and estates, rather than the parents’ marginal rate. In previous years, the kiddie tax essentially undid the benefits of shifting investment income to one’s children. By applying the parents’ marginal rate to that income, the tax result was about the same as if the parents had retained ownership of the assets. But the TCJA’s approach can push children into a higher tax bracket than their parents in many cases. That’s because the highest marginal tax rate for trusts and estates — currently, 37% — kicks in when taxable income exceeds $12,500. For individuals, that rate doesn’t apply until taxable income reaches $500,000 ($600,000 for joint filers).
Suppose that a married couple filing jointly has taxable income of $250,000 per year, placing them in the 24% tax bracket. If they transfer investments generating $30,000 in ordinary taxable income to their 17-year-old daughter, she is taxed as follows: Assuming she has no earned income, the first $1,050 is tax-free and the next $1,050 is taxed according to the regular individual income tax rate (10%, for a tax of $105). The remaining $27,900 is taxed at the rates for trusts and estates. In 2018, that means the first $2,550 is taxed at 10% ($255 in tax), the next $6,600 is taxed at 24% ($1,584 in tax), the next $3,350 is taxed at 35% ($1,172.50) and the remaining $15,400 is taxed at 37% ($5,698), for a total tax of $8,814.50. Had the parents retained the investments, the tax would have been $7,200 ($30,000 × 24%). In other words, income shifting increases the family’s tax bill by more than $1,600.
Note that the calculation of the kiddie tax will be different if a child has earned income or if the assets generate long-term capital gains.
Although the new kiddie tax rules can lead to harsh consequences for many families, it may create tax-saving opportunities for higher-income taxpayers. Because the tax is now applied using the progressive rate structure for trusts and estates, rather than the parents’ marginal rate, parents can shift a limited amount of investment income to their children at lower tax rates. For example, parents in the 37% tax bracket can shift income up to $14,600 (the $2,100 unearned income threshold plus $12,500) before the 37% rate applies.
There are several ways to shift income to your kids without triggering kiddie tax issues. For example, you can:
- Transfer investments that emphasize capital appreciation over current income, allowing the child to defer income until the kiddie tax no longer applies,
- Transfer tax-deferred savings bonds,
- Transfer tax-exempt municipal bonds,
- Contribute to 529 college savings plans (see “How 529 plan benefits are expanding”), and
- Hire your kids.
Employing your children can be beneficial because earned income isn’t subject to kiddie tax; plus, your business can deduct the expense.
LOOK BEFORE LEAPING
Depending on your circumstances, shifting income to your children may reduce your tax bill. But given the risk that income-shifting may increase it, look closely at the kiddie tax before you attempt this strategy.