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 who 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 2018), part of that income may be subject to tax at the rates that apply to trusts and estates.
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 the Kiddie Tax works
The first $1,050 of the child's income is tax-free, covered by the child's standard deduction. The next $1,050 is subject to the child's tax rate. Any additional earnings are taxed at the rates that apply to trusts and estates. The new brackets for 2018, based on trust income, are as follows:
|Up to $2,550||10%|
|$2,550 to $9,150||24%|
|$9,150 to $12,500||35%|
Depending on your client's situation, this may increase or decrease their amount of tax liability.
How will the Kiddie Tax affect my clients?
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. While there are still some ways to shift income to children, it is becoming increasingly difficult as legislators slowly catch-up to outstanding loopholes.
This is why it is important to review all of your client's accounts, and to ask about any accounts that may be held in a child's name. 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. 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 replacing 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, avoiding the Kiddie Tax entirely. Assets in a 529 plan also have far less impact on financial aid, and the accounts can accommodate large sums.
If your client has an UGMA/UTMA account and wants to switch to a 529 plan, there are a few things to consider. Investments from an UGMA/UTMA account can't be directly transferred, so they will have to be sold prior to opening the 529 plan. This may trigger the Kiddie Tax if there are any taxable gains. Also, even though the custodial 529 account is considered a parental asset on the FASFA, the beneficiary will have the right to take direct ownership when he or she reaches legal age. And unlike traditional 529 plans, beneficiary changes are not permitted until the beneficiary reaches legal age. It is usually a good idea to set up two 529 plans, one funded by the UGMA/UTMA, and a second for any future funding so that the parent retains control of the account.
Find your 529 plan - Select your state below
Did you know that residents are not limited to investing in their own state's plan? Another state may offer a plan that performs better and has lower fees. Select your state below to see your state's plan and other options.
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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.
ORIGINAL POST: 07/27/16; UPDATED 03/12/18