Your New Baby

Children's Taxes, Tax Returns, and the Kiddie Tax

Naturally, you want to minimize taxes in order to keep your hard-earned money from disappearing. Shifting assets to your children (who have a lower tax bracket) is one way to accomplish this.

How do you get the money to your child?

  1. Tax-Free Gifts. Thanks to the "gift-tax exclusion," in 2020 you can give up to $15,000 ($30,000 if you give gifts jointly with your spouse and elect to split the gifts) to as many individuals as you wish. The recipients do not have to pay a gift tax on this money. However, if in 2020 your kindness is greater than $15,000 (or $30,000 jointly) a year, you—as the donor—may be subject to the gift tax on the excess. For lifetime transfers, there is also an applicable credit amount that allows you to transfer up to $11.58 million during your lifetime free of gift tax. Any amount gifted over $11.58 million is subjected to current gift tax. There are also gift tax exclusions, such as payments on behalf of a donee for health care and/or educational expenses paid directly to the provider. The gift tax rates are generally the same as the estate tax rates (in 2019, the top rate is 37%).
  2. Transfer Growth Stocks. You can cut your capital gains tax on appreciated stocks by transferring them into your child's custodial account. This type of stock is purchased in anticipation of its rising in price. Growth stocks typically pay very low or no dividends, which are currently taxable. Sell the stock only after your child turns 19, or age 24 if a full-time student. At that point, the capital gain portion is taxed at your child's tax rate, which could be as low as 0%. Growth stock investments for your child's benefit make good sense when your child is a newborn since he or she has more than ten years before college. This type of investment yields little or no immediate income, so you'll have minimal tax to pay.
  3. Transfer Appreciated Investments. As with growth stocks, when these securities are sold, the profit or gain will be taxed at the child's lower rate, not your higher one, unless the "Kiddie Tax" rules apply (see below).

The "Kiddie Tax"

The recently passed SECURE Act provides for many changes to retirement accounts as well as some tax-related items.

One change impacts the “kiddie tax,” which applies to the unearned income of minors generated within custodial UTMA or UGMA accounts. Unearned income above a certain threshold – $2,200 for 2019 (and 2020) – is subject to the kiddie tax. The tax was designed to prevent families from holding investments in the name of a minor to avoid or limit taxation.

Until 2018, the kiddie tax applied the parent’s marginal tax rate to unearned income above the threshold. The passage of the Tax Cuts and Jobs Act (TCJA) made changes to base the kiddie tax on the same tax schedule that applies to trusts and estates.

For 2020 and forward, the new law reverts the kiddie tax back to the previous method of applying the parent’s marginal tax rate.

Taxpayers have the option of applying either method – the tax rate associated with trusts and estates, or the parent’s marginal tax rate for tax years 2018 and 2019. A taxpayer wishing to change the method for 2018 would have to file an amended tax return. For taxpayers holding custodial accounts and filing 2019 taxes in the next few months, a key decision will be which method to use.

For tax year 2019, here’s a comparison of the trust/estate tax rate schedule vs. married filing jointly tax schedule:

Income Tax If taxable income is over But not over The Tax is  Of the amount over
Married/filing Jointly and qualifying widow(er)s  $                               -    $              19,400.00 $         0.00 + 10% $0.00
   $                     19,400.00  $              78,950.00 $  1,940.00 + 12% $19,400.00
   $                     78,950.00  $            168,400.00 $  9,086.00 + 22% $78,950.00
   $                   168,400.00  $            321,450.00 $ 28,765.00 + 24% $168,400.00
   $                   321,450.00  $            408,200.00 $ 65,497.00 + 32% $321,450.00
   $                   408,200.00  $            612,350.00 $ 93,257.00 + 35% $408,200.00
   $                   612,350.00   $164,709.50 + 37% $612,350.00

 

Income Tax If taxable income is over But not over The Tax is  Of the amount over
Estates and Trusts  $                             -   $               2,600.00 $       0.00 + 10% $0.00
   $                       2,600.00  $              9,300.00 $    260.00 + 24% $2,600.00
   $                       9,300.00  $            12,750.00 $  1,868.00 + 35% $9,300.00
   $                     12,750.00     $ 3,075.50 +  37% $12,750.00

When comparing the two tax calculations options for 2019 here are some considerations.:

• Parents subject to the highest marginal tax rate already, or have lower amounts of unearned income subject to the kiddie tax, may find the trust and estate tax schedule more beneficial
• Parents in a lower-to-moderate tax bracket with larger amounts of unearned income subject to the kiddie tax may find that using their own marginal tax bracket (vs. the tax brackets for trusts and estates) may be more beneficial
• Given the complexity around the kiddie tax calculation, it is critical to work with a tax professional who can calculate each scenario to determine the best option

Planning considerations for tax mitigation
Depending on the amount of unearned income, parents may want to consult a financial advisor for strategies to mitigate the tax impact. For example, parents may want to change the underlying investments and select others that may not generate as much income or dividends subject to the tax.
If the funds are being saved for education, parents may consider transferring the account to a 529 college savings plan, where earnings grow tax free. Also distributions for qualified education expenses would not be subject to taxation. There are specific rules applied to assets in a 529 plan that originated from a custodial account, so it’s critical to consult with a financial advisor or tax professional.

Recently, Congress repealed the TCJA kiddie tax for 2020 and beyond. Facts and circumstances will dictate whether taxpayers should pay the TCJA or the non-TCJA kiddie tax for 2019 and whether they should amend their 2018 tax returns to secure potential refunds.

 

 

Filing Tax Returns for Your Child

When your children have income, they must pay taxes. However, they may not need to file their own tax return. If they are under age 19, or age 24 if a full-time student, and have unearned income over $1,100 (Same as 2019) and earned income $12,200 ($11,000 in 2019) consisting only of interest and dividends that were not subject to backup withholding, and they made no estimated payments, you may elect to include the child's income on your return. If you elect to do this, enter their income as "other income" on your return and file Form 8814.

This may boost your taxable income, put you in a higher tax bracket and, therefore, work to your disadvantage; or, it may work to your advantage if you can deduct more investment interest expense because of your child's income inclusion.

If you do not include the child's income on your tax return, then they may be required to file their own return and Form 8615.

Let's summarize:

 

2020 Form 8814

2020 Form 8615

 

Parents include Child's Unearned Income

Child Files Own Tax Return for Unearned Income

Under age 19 or a full-time student under age 24

First $1,100 (same as 2019) is tax free

First $1,100 (same as 2019) is tax free

 

$1,101 to $2,200 (same as 2019) taxed at 10%.

Dividends and the long-term capital gain portion are taxed at a maximum rate of 0%

$1,101 to $2,100 (same as 2019)) taxed at 10%.

Dividends and the long-term capital gain portion are taxed at a maximum rate of 0%

 

Over $2,200 (same as 2019) is taxed at parents' tax rate

Over $2,200 (same as 2019) is taxed at parents' tax rate

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax professional.

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