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By Bonnie Scotella, CPA, MST            Senior Tax Manager

Flying under the radar in the passing of the Tax Cuts and Jobs Act was the changes made to how children’s investments and other unearned income is taxed, otherwise known as “kiddie tax.” The Act put new provisions in place potentially creating tax saving opportunities to some families by transferring assets into their children’s name.

What is Kiddie Tax?

Under the Tax Reform Act of 1986, kiddie tax was introduced in order to close a loophole through which wealthy folks were getting investment income taxed at lower rates by transferring assets to their children under the age of 19 or who were full-time college students under the age of 24.

In simple terms, kiddie tax was really a taxing threshold and not a separate tax. In general, the first $1,050 of a child’s unearned investment income (interest, dividends and capital gains distributions) was tax free, while the next $1,050 was taxed at the child’s income tax rate. Any unearned income above $2,100 was taxed at the parent’s tax rate.

Kiddie Tax Post Tax Reform

Tax reform brings fundamental changes for the way kiddie tax works. Just as before, there is no tax on the first $1,050 and the minimal child’s tax rate is applied to the next $1,050. The real game-changer is unearned income above the $2,100 threshold is no longer taxed based on the parent’s income. Starting in 2018, investment earnings in excess of $2,100 will be taxed at the trust and estate rates, as outlined below:

  • Up to $2,550 – 10%
  • $2,550 to $9,150 – 24%
  • $9,150 to $12,500 – 35%
  • Over $12,500 – 37%

Even with the new lowered individual tax rates, investment income taxed under the trust and estate tax rates will provide an opportunity that is advantageous for tax savings. For example, if parents transferred assets generating $12,500 of unearned income to their children and the old rules still applied, parents with a taxable income of $500,000 would have had to apply their 39.6 percent tax rate costing them $4,223 in tax. Applying the trust tax rates produces a kiddie tax bill of just $2,382 on the child’s investment income – a savings of $1,841.

However, there are some additional considerations before applying this technique. This approach would not be beneficial for children with substantial income as the estate and trust tax schedules reaches a very high rate of 37 percent at only $12,501. Beyond that, in order for a child to report unearned income they have to have income-generating assets in their name – which can create cause for concern for some parents knowing their children have financial control.

Is Kiddie Tax the Right Escape for Your Family?

The kiddie tax might provide a tax escape for your family if it is approached properly. Considerations should be discussed with your tax advisor before transferring any assets to your children to make sure it is the best strategy.

If you already have investments in your child’s name, it will be important to closely monitor the amount of unearned income they are generating to both take advantage of the lowest tax bracket and avoid being pushed into the highest bracket. With new lower individual income tax rates for parents, this approach could easily cost more in taxes if not closely monitored.

To properly take advantage of these new rules and plan appropriately for the year, contact our tax advisors as soon as possible.

Flying under the radar in the passing of the Tax Cuts and Jobs Act was the changes made to how children’s investments and other unearned income is taxed, otherwise known as “kiddie tax.” The Act put new provisions in place potentially creating tax saving opportunities to some families by transferring assets into their children’s name.

What is Kiddie Tax?

Under the Tax Reform Act of 1986, kiddie tax was introduced in order to close a loophole through which wealthy folks were getting investment income taxed at lower rates by transferring assets to their children under the age of 19 or who were full-time college students under the age of 24.

In simple terms, kiddie tax was really a taxing threshold and not a separate tax. In general, the first $1,050 of a child’s unearned investment income (interest, dividends and capital gains distributions) was tax free, while the next $1,050 was taxed at the child’s income tax rate. Any unearned income above $2,100 was taxed at the parent’s tax rate.

Kiddie Tax Post Tax Reform

Tax reform brings fundamental changes for the way kiddie tax works. Just as before, there is no tax on the first $1,050 and the minimal child’s tax rate is applied to the next $1,050. The real game-changer is unearned income above the $2,100 threshold is no longer taxed based on the parent’s income. Starting in 2018, investment earnings in excess of $2,100 will be taxed at the trust and estate rates, as outlined below:

  • Up to $2,550 – 10%
  • $2,550 to $9,150 – 24%
  • $9,150 to $12,500 – 35%
  • Over $12,500 – 37%

Even with the new lowered individual tax rates, investment income taxed under the trust and estate tax rates will provide an opportunity that is advantageous for tax savings. For example, if parents transferred assets generating $15,000 of unearned income to their children and the old rules still applied, parents with a taxable income of $500,000 would have had to apply their 39.6 percent tax rate costing them $4,223 in tax. Applying the trust tax rates produces a kiddie tax bill of just $2,382 on the child’s investment income – a savings of $1,841.

However, there are some additional considerations before applying this technique. This approach would not be beneficial for children with substantial income as the estate and trust tax schedules reaches a very high rate of 37 percent at only $12,501. Beyond that, in order for a child to report unearned income they have to have income-generating assets in their name – which can create cause for concern for some parents knowing their children have financial control.

Is Kiddie Tax the Right Escape for Your Family?

The kiddie tax might provide a tax escape for your family if it is approached properly. Considerations should be discussed with your tax advisor before transferring any assets to your children to make sure it is the best strategy.

If you already have investments in your child’s name, it will be important to closely monitor the amount of unearned income they are generating to both take advantage of the lowest tax bracket and avoid being pushed into the highest bracket. With new lower individual income tax rates for parents, this approach could easily cost more in taxes if not closely monitored.

To properly take advantage of these new rules and plan appropriately for the year, contact our tax advisors as soon as possible.

Want to reach the author? Email Bonnie Scotella or contact her at 248.244.3212.