By: Randall A. Denha, J.D., LL.M.
At some point in each of our lives we are interested in transferring wealth or opportunity to the next generation. The former may be taxable while the latter isn’t. At one time (before 1986), parents shifted investments to children so that interest and dividend income from the investments would be reported on the children’s returns. Often, children paid little or no tax because they sheltered the investment income with their standard deduction and exemption deduction and paid tax at their low tax rates.
Then in 1986, Congress closed this tax strategy in three ways. First, only one exemption deduction per person is allowed. If you claim your child as a dependent on your return, your child loses his or her personal exemption deduction. Second, if you claim your child as a dependent on your return, your child’s standard deduction decreases to the greater of $1,000 or the compensation income of the child plus $300. Thus, if your child’s compensation income is $400, your child’s standard deduction is $1,000. If your child’s compensation income is $1,800 then your child’s standard deduction is $2,100. This increased standard deduction is one advantage of hiring your children to work for you.
Third, if your child is subject to the kiddie tax, your child’s investment income over $2,000 may be taxed at your tax rate. Dependent children with investment income greater than $2,000 may be subject to the kiddie tax if they are under the age of 19 or are children ages 19 through 23 who are full-time students and who do not earn more than one-half of their own support. A child who turns 20 (or 24) by the end of the tax year is not subject to the kiddie tax. To be considered a student, a child must attend school full time during at least five months of the year. It doesn’t matter whether the child is claimed as a dependent on the parent’s return. However, the tax does not apply to a child under 24 who is married and files a joint tax return.
How can you stay within the kiddie tax limit? Obviously, you don’t want a child subject to the kiddie tax to have investment income over the kiddie tax threshold amount. Luckily, this is a fairly high threshold. For example, a child whose investments earn 5% per year would have to have over $36,000 in cash or property to earn $1,900. Remember that there is no kiddie tax for children ages 19 to 23 who are not full-time students or who provide more than half of their own support from their earned income or for children 24 years old and over, even if they are their parents’ dependents. These children are taxed like adults — all their income is taxed at their own income tax rates. If the kiddie tax doesn’t apply to your children, you can give them all the money or property you want and their unearned income will be taxed at their individual rates, which will most likely be lower than yours. Under the newly enacted tax act, there could be considerable tax savings by properly structuring sales and other dispositions of assets given to lower income taxpayers not subject to the kiddie tax.
But if your children fall within the kiddie tax rules, there is another way to stay within the limit — give your child investments that appreciate in value over time but don’t generate much or any taxable income until they’re sold. If you wait until after the child turns 24 to sell, there’s no need to worry about the kiddie tax.
Here are some additional ideas for avoiding the Kiddie Tax.
1. U.S. savings bonds. You could purchase U.S. savings bonds for your child and defer the payment of interest until the child is no longer subject to the kiddie tax. All the interest would then be taxed at the child’s tax rate.
2. Municipal bonds. You could buy a muni bond for your child that matures after your child is no longer subject to the kiddie tax. You won’t owe federal tax on the interest the bond earns while your child is younger (and subject to the kiddie tax) because muni bonds are exempt from federal income tax. If the muni bond is ultimately sold at a profit, it would be taxed as a capital gain at the child’s capital gains tax rate, provided you waited until the child was no longer subject to the kiddie tax.
3. Growth stocks or growth mutual funds that pay no dividends. You can give your child stocks, or funds made up of stocks, from companies that reinvest their profits for future growth rather than paying them to shareholders as taxable dividends. You could then wait until after the child ceases to be subject to the kiddie tax to sell — for example, the year the child graduates from (or drops out of) college or turns 24, and the profit will be taxed at the child’s capital gains rate.
4. Index funds. You could also look into buying funds whose investments mirror a stock index or some other criteria and are likely to generate minimal taxable annual income.
5. Tax-managed mutual funds. These funds are specifically designed to generate little taxable income. Again, you could sell them after the child ceases to be subject to the kiddie tax.
6. Treasury bills. If your child is almost at the age when he or she will not be subject to the kiddie tax, buy a Treasury bill that won’t mature until the no-kiddie-tax year. That way, the child won’t earn any interest while the kiddie tax still applies.
7. Real Estate. You can purchase real estate that appreciates in value.
8. Consider splitting your child’s income with a trust. A trust is a separate tax entity. Trusts pay tax on income that is kept in the trust and not paid to your child. The first $2,450 of trust taxable income is taxed at a 15% tax rate. Thus, up to $4,250 ($2,450 in the trust and $2,000 distributed to your child) of income is taxed at a 10% or 15% tax rate. Although this strategy is worth considering, few parents use it because of the initial cost of setting up a trust and the annual cost of filing trust returns.
Many parents shift income to their children so they can save money for the child’s college costs at a lower tax rate. However, until the child gets older, the child may pay tax at the parent’s tax rate. You can avoid this higher rate of tax by knowing how much income your child can receive before your tax rate applies and choosing investments that do not increase your child’s taxable income.
NOTE: If you are investing money in a child’s name to save money for college, you should consider a 529 Plan or “qualified tuition plan”. They are generally better vehicles for such savings, particularly when the child is potentially subject to the kiddie tax.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.