How the kiddie tax may impact your clients

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The Kiddie Tax is one of those subtle, oft-overlooked pieces of the tax code that people forget about until it hits them. Because it comes up so infrequently, even people that understand it have to brush up on it when it does. Further, it can have a substantial impact on high net worth investors under the right circumstances. You may be able to save your clients a substantial sum by keeping vigilant for situations that might trigger this tax rule.

What is the Kiddie Tax?

The Kiddie Tax was written to close a tax loophole that allowed high-income individuals to transfer their earnings to their children. This would, previously, shelter the assets and take advantage of their child's lower tax rate. Under the Kiddie Tax, however, "...if the child's interest, dividends, and other unearned income total more than $2,100 (in 2016), part of that income may be subject to tax at the parent's tax rate instead of the child's tax rate." (Source - Topic 553 - Kiddie Tax - IRS.gov)

Normally, the unearned income of the child will not be counted towards the Kiddie Tax if they are over 19. However, if the child is a full-time college student between the ages of 19 and under 24, and they aren't able to provide more than half of their own support from their own earned income, they will still be subject to the Kiddie Tax.

How it works is:

• The first $1,050 of the child's income is tax-free.
• The next $1,050 is taxed at the child's rate.
• Any additional earnings are taxed at the parent's rate.

RELATED: UGMA/UTMA conversions to 529: When do they make sense?

How could my clients be impacted?

Clients that have substantial income may elect to shift some of that income to their children to take advantage of their lower tax bracket. This had been particularly popular with UGMA/UTMA accounts prior to 2008 when the Kiddie Tax law was changed to include children 19 to 23 enrolled in college. There are still some ways to shift income to children, though it is becoming increasingly difficult as legislators slowly catch-up to outstanding loopholes.

This is why it is important to review both the accounts of your clients and to ask about any accounts that are held in the name of their children. Assets and income of the child have the most substantial impact on financial aid eligibility, and may inadvertently subject your clients to the Kiddie Tax itself. If there is any question to this effect, it may be worth consulting with a tax professional.

Benefits of a 529 plan

529 savings plans have been taking over UGMA/UTMA accounts to some extent. This is because savings in a 529 plan grow tax-deferred, and can be withdrawn tax-free if used to pay for qualified higher education expenses, so earnings could avoid the Kiddie Tax entirely. Assets in a 529 plan also have far less impact on financial aid, and the accounts can accommodate large sums.

Further, UGMA/UTMA accounts can be used to fund a 529 plan, subject to certain restrictions. 529 plans can only accept cash, so the UGMA/UTMA will need to be liquidated prior to funding the plan. Second, the 529 account will be designated as a UGMA/UTMA 529 plan. This is because as an UGMA/UTMA ownership transfers to the beneficiary at their age of majority. It is usually a good idea to set up two 529 plans for this reason: One funded by the UGMA/UTMA, and a second for any future funding so that the parent retains control of the account.

RELATED: Grandparent FAQ: UTMA Account Contributions

This information does not constitute tax advice and is provided for informational purposes only. Please consult your tax advisor, financial advisor, local taxing authority, and/or plan provider or sponsor for more information.