Historically, high-income families moved investments into the names of their children so their investment income would be taxed at a lower rate. Congress wasn’t a fan of this strategy and retaliated with the Kiddie Tax in 1986, which was recently restructured. What will the new Kiddie Tax mean for your kids’ custodial accounts? And, how will it impact your taxes?
As with many other areas of the tax code, the Kiddie Tax was restructured by the Tax Cuts and Jobs Act (TCJA) signed in December 2017. The Kiddie Tax applies to children under the age of 19 and full-time students, under age 24, who don’t support themselves financially.
The Kiddie Tax pertains solely to unearned income such as dividends, interest, and capital gains. Did your daughter invest in a mutual fund this year? Did her grandparents gift her shares of stock? The interest, dividends, or gains generated by those investments are considered unearned income and are subject to the Kiddie Tax.
Previously, the first $2,100 in unearned income was generally tax-free. Income greater than $2,100 was taxed at the parents’ rate. If the parents were in a high-tax bracket, that rate could be as high as 39.6 percent for ordinary income and 20 percent for long-term capital gains and qualified dividends.
Starting in 2018, the first $2,100 in unearned income remains tax-free. Additional income, however, is taxed at “Estate and Trust” tax rates. The parents’ tax bracket is completely disregarded, simplifying the calculation. Under the old rules, the income of the siblings in a family with multiple children, would impact the tax bill for all siblings. Now everyone’s earnings are considered separately, making it easier to calculate tax projections for children. This will be the case until at least 2025, when this provision is scheduled to sunset.
So, are the new, simplified rates more beneficial than the previous ones? It all depends. For children, interest and short-term capital gains are taxed at 37 percent once they exceed $12,500. (See the chart below.) For a couple who is married and filing jointly, the 37 percent bracket doesn’t take effect until they have more than $600,000 in taxable income. In other words, a child can reach the highest bracket much quicker than the parents can.
The same is true for long-term capital gains rates. That tax doesn’t reach 20 percent until the parent’s taxable income is greater than $77,200. However, the Estate and Trust tax table reaches 20 percent for the child when gains are greater than just $12,700.
Estate, Trust, or Unearned Income for Qualified Children
Taxable Income/Tax Rate
Up to $2,550 - 10%
$2,551 to $9,150 - 24%
$9,151 to $12,500 - 35%
$12,501 & up - 37%
Long Term Capital Gains & Qualified Dividends Tax
Taxable Gains & Dividends/Tax Rate
Up to $2,600 - 0%
$2,601 to $12,700 - 15%
$12,701 & up - 20%
Will “simpler” translate to “lower” when it comes to your tax bill? Maybe or maybe not.
Here's an examples of how it could play out. Let’s assume Jane is 15-years old and has $7,100 in dividends subject to the Kiddie Tax this year. The first $2,100 is not taxed. That leaves $5,000 in net unearned income. Of that, the first $2,550 is taxed at 10 percent ($255) and the remaining $2,450 is taxed at 24 percent ($588). Jane’s total tax bill would be $843. Under the old rules, if her parents were married and had taxable income of $77,400 or more, her tax would have been higher – anywhere from $257 to $1,007 higher. So, it works out well for Jane!
Here’s another example. Jill is 18 and has some stock her grandparents left her in a Uniform Transfer to Minors Act (UTMA) account. To help with college expenses, Jill will sell some of her investments, generating a $50,000 long-term gain. A majority of the gain will be taxed at the top Estate and Trust rate of 20 percent resulting in a tax bill of $8,555. Under the old tax rules, the 20% would only apply if her parents’ taxable income was over $479,000. Otherwise, either 0% or 15% would apply – resulting in less tax being paid.
The Kiddie Tax also applies to distributions received from an Inherited IRA account. If it’s an option, it is usually better to pass to heirs a Roth IRA instead of a Traditional IRA in order to minimize the tax impact.
While the calculation is now more straightforward, the impact on the overall tax bill is based on individual circumstances. Children of higher-income parents will likely have a lower tax bill, but certain situations could increase the tax bill for children of parents with a lower net income.
Parents and grandparents who are gifting investments to their children or grandchildren need to consider the tax impact prior to gifting. Several factors can affect your child’s tax bill, so it’s important to consult with your tax advisor to understand the impact on the family’s income tax situation.