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How To Downplay The Kiddie Tax
From a tax-planning standpoint, it's often good to get investments out of the hands of highly taxed parents and into the accounts of children or grandchildren who are in much lower tax brackets. This can result in overall savings on current taxes while also removing assets from the parents' taxable estate. Of course, you have to be willing to part with your stocks or bonds, but that might make sense for other reasons, too.
Still, there's one problem with this simple solution. A tax-law provision known as the kiddie tax could negate many of the advantages of giving investments to your offspring.
Generally, investment income is taxed to the person who receives it—to the owner of the assets. So if you move stocks or mutual funds into the names of your children, they (rather than you) will be taxed, often at a much lower tax rate than yours. Suppose you're paying at the highest possible rates—you're in the top 39.6% income tax bracket and you also owe the 3.8% surtax on net investment income. That gives you a combined federal tax rate of 43.4%, whereas your son or daughter might be in the 10% or 15% tax bracket for ordinary income. On an investment generating $10,000 a year, having a child own it potentially could save your family the difference between 43.4% and 10%, or $3,340 in tax cost.
But then there's the kiddie tax. For a child who is your dependent and under age 19, or a full-time student under age 24, unearned income from investments that exceeds a specified threshold—$2,100 in 2017—is taxed at the parents' tax rate. So in the example of an investment generating $10,000 a year, $7,900 of the income could end up being taxed at the 43.4% rate, and then your family would lose all but $701 of the overall tax savings.
Nevertheless, there are several ways you can mitigate the effects of the kiddie tax. For instance:
- Keep an eye on the annual threshold. You might limit the asset transfer to an amount that would generate no more than about $2,000 in unearned income. Once the child is old enough to avoid the kiddie tax, you could give more.
- Suggest that your children manage their own holdings to keep investment income at a minimum—for example, by holding municipal bonds or stocks that don't pay dividends. Again, that could change once they're no longer subject to the kiddie tax.
- Consider other ways to transfer income—perhaps by hiring your son or daughter to work for your company. Because wages aren't unearned income, that amount won't count toward the kiddie tax threshold.
In any event, be aware of the possible tax ramifications of family income-shifting. It can be a sound technique for many parents, but you need to consider your own situation, with help from your tax advisor.