What’s the Kiddie Tax?
Under the Tax Reform Act of 1986, a new “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 ’86 rule, unearned income (mainly investment income like stock dividends, interest, and capital gains) gets separated out for any children in the family and to the extent that this unearned income exceeded a fairly low threshold, it was taxed not at the child’s low tax rate, but rather, at whatever marginal rate the parents were paying on their own income. This, effectively, eliminated a substantial incentive to move assets and the income they produced to one’s children (and somewhat undermined the utility of UTMA/UGMA accounts). [For reference, UTMA/UGMA accounts are accounts owned by the child, but managed by the parent or other trustee on behalf of the child, and at one time, such accounts were often used for college savings.]
The computation has always been a bit messy, as it required finishing the parents’ taxes before being able to compute this.
Nevertheless, even with the Kiddie Tax in place, there were some small opportunities to use the child’s low bracket and standard deduction, inasmuch as, for example, in 2017, the child’s standard deduction (for a child declared as a dependent on a parent’s return, and for a child with no earned income) — was $1050. And the Kiddie Tax threshold was an additional $1050. So up to $2100 of unearned income belonging to the child was tax-free, and any unearned income above that was taxed at the parents’ rates.
With recent low interest rates, that could have been the interest on over $100,000 of fixed-income investments, or the dividends on a similarly large stock portfolio.
But every penny of such income above that $2100 (2017) threshold would be taxed at the marginal rate based on the income of the parents.
How has this changed under the TCJA (Tax Cuts and Jobs Act of 2017)?
The Kiddie Tax remains, and the child’s standard deduction and the Kiddie Tax threshold both still remain at $1050 — so there is no tax at all on a child’s unearned income of up to $2100, just as before.
However, the tax rate that applies to any income above that threshold is no longer the rate based on the parental income. Instead, the tax is based on the tax schedule used for Estates and Trusts. This compressed tax schedule means that now there are some (small) low tax brackets to take advantage of. For children with substantial income, this will be a disadvantage, as the Estates and Trust tax schedule reaches very high tax rates very quickly (37% at only $12,500). But it does introduce the opportunity to take advantage of those lower brackets — which previously didn’t apply at all.
The first $2550 of unearned income (above the $2100 threshold) will be taxed at 10% — and if that is all long-term capital gains or qualified dividends, it may even qualify for the 0% rate.
The next $6600 will be taxed at 24% (same bracket as MFJ reaches when family income is over $165k), so at this point, this starts looking more like the typical rates of the old system. However, even this may still be a beneficial rate for the kids, especially for very high income parents.
Nevertheless, that $2550 in the lowest bracket expands the opportunity to realize investment income for the child at lower tax rates than for most parents — if the entire unearned income is LTCGs and qualified dividends, then $4650 (the combination of that lowest bracket plus the $2100 thresholds) could now be potentially tax-free.
The bottom line is that it’s going to be more important than ever to know how much unearned income your child’s investments are generating, and to manage it carefully — both to take advantage of that lowest bracket, as well as to avoid being pushed into the highest bracket (which is much easier now, whereas previously very few people ever reached it), including avoiding the potential of having the child’s income taxed at a rate higher than that of the parents!
And the time to plan for this is as early in the year as possible before your child’s investments produce that income.
If you have investments in your child’s name, (often it might be in a UTMA account) — we encourage you to contact your financial and tax advisors as soon as possible and plan for these new rules.
As usual, we remind you that this article is just for educational purposes, and is not tax or investment advice and should not be relied upon by any person. We recommend working with a professional tax preparer (EA or CPA) and consulting with a financial advisor (such as a fee-only financial planner) to assess how this all might fit into your own personal situation.