The “Tax for Certain Children Who Have Unearned Income,” or “Kiddie Tax” as it’s more commonly called, was first introduced through the Tax Reform Act of 1986. Under the original act, a child’s unearned income above a certain threshold was taxed at his/her parents’ highest marginal tax rate. President Trump’s Tax Cuts and Jobs Act of 2017 made significant changes to the Kiddie Tax law. Whether you’re looking to reduce the tax on your child’s income, shift income-producing assets to your children, or fund your child’s education, it is important to understand these changes.
Who is subject to the Kiddie Tax?
Children age 19 and younger with unearned income may be subject to the Kiddie Tax. Additionally, individuals between the ages of 19 and 23 who are full-time students and whose earned income does not exceed one-half of the annual cost to support them are also subject to Kiddie Tax. A child is considered a full-time student if they attend school full-time during at least five months of the year.
Kiddie Tax Prior to 2018
Under the old Kiddie Tax law, a child would pay tax at his/her own individual tax rate on unearned income up to a certain threshold. “Unearned income” refers to income (other than wages, salaries, professional fees and other compensation) such as interest, dividends, and capital gains. The old Kiddie Tax limits allowed a child’s first $1,050 of unearned income to be tax-free, and the second $1,050 was taxed at the child’s tax rate. All unearned income over $2,100 was taxed at the parents’ top marginal rate, which could be as high as 39.6%. Calculating Kiddie Tax was complicated, as parents of more than one child subject to Kiddie Tax had to combine the net unearned income of all children to calculate tax on one child.
Kiddie Tax from 2018 through 2025
President Trump’s tax overhaul changed the tax rates for the Kiddie Tax. Under the new law, the first $1,100 in unearned income is still tax-free, and the second $1,100 is still taxed at the child’s tax rate. However, net unearned income above this $2,200 threshold is now taxed using the tax rates for trusts and estates, rather than the parents’ top marginal rates. The new tax rates for unearned income above the $2,200 threshold are as follows:
- Up to $2,600: 10%
- $2,601 to $9,300: 24%
- $9,301 to $12,750: 35%
- Above $12,750: 37%
Applying a single set of tax rates to a child’s unearned income has significantly simplified the Kiddie Tax. A child’s tax rate on unearned income is no longer affected by the earnings of his or her parents and/or siblings and merely follows the tax brackets of trusts and estates. Unfortunately, this simpler form of taxation could also result in a higher tax liability. Under the new law, the highest tax rate of 37% starts when income exceeds $12,750. Previously, the top 37% tax rate would only have been applied to taxable income above $612,350 (for children of a married couple filing jointly). Additionally, under the new rules, the top long-term capital gain tax rate of 20% begins when the child’s income exceeds $12,950. If children were still being taxed at their parents’ rate, the top 20% capital gain tax rate would only have been applied to taxable income above $488,850 (the beginning 20% tax bracket for joint filers in 2019). The long-term capital gain and qualified dividend tax rates for trusts and estates at different income levels are as follows:
Long-Term Capital Gains and Qualified Dividends:
- Up to $2,650: 0%
- $2,651-12,950: 15%
- Above $12,950: 20%
The trust and estate tax rate structure could be unfavorable because the rate brackets are compressed compared to the brackets for single individuals. In other words, the Kiddie Tax rules can override the lower rates that would otherwise apply to an affected child’s unearned income.
In addition, children with unearned income are now subject to the much lower estate and trust income threshold for purposes of the net investment income tax (NIIT). Under the new rules, a 3.8% surtax on net investment income is imposed when the child’s adjusted gross income exceeds $12,950 (for 2019). This means a child’s tax rate could be as high as 40.8% (37% + 3.8% NIIT).
Strategies that could reduce the Kiddie Tax for 2019 and beyond
With proper planning, the new Kiddie Tax provisions can potentially help middle-class taxpayers, but the largest benefits could go to those with the financial resources to provide their children with enough investment income to max out its low tax rates. Under previous tax law, the first dollar above the $2,100 initial limit could have potentially been taxed at the 37% tax rate. Now, parents will have a big incentive to move enough assets to generate a total of $11,500 in income attributable to their kids, because the income will get taxed at relatively favorable tax rates of 10% to 24%.
There is also an opportunity for savings related to the favorable rates for qualified dividends and long-term capital gains. Under the previous tax laws, the preferred rates on qualified dividends and long-term capital gains were determined by parental income, with parents in the lowest two tax brackets paying 0%, or 15%, and the top-bracket taxpayers, who paid 20%. Now, the trust and estate brackets determine that taxation. Under the new law, up to $2,650 in qualified dividends or capital gains above the first $2,200 in income could get the preferred 0% rate, with 15% rates applying on further gains up to $12,950, at which point the 20% bracket applies, as well as the 3.8% NIIT.
Funding your child’s education
The new tax law may also impact the way parents fund their children’s education. The 529 savings account was originally set up as a tax-advantaged investment account. Earnings within a 529 plan are not subject to federal or state taxation as long as distributions are used to pay for eligible higher-education expenses. The new law expanded the 529 savings plan to include expenses for private, public, and religious education from kindergarten through 12th grade. Beginning in 2018, parents can withdraw up to $10,000 tax-free from a 529 plan to pay for enrollment at an elementary or secondary public, private, or religious school.
The downside to a 529 plan is that contributions are not deductible by the contributor and are treated as a gift to the named beneficiary for gift and generation-skipping transfer tax purposes. Payment of tuition directly to the institution is not considered a gift, so parents may wish to pay the tuition for a child directly to the school and make separate gifts to the child’s custodial or trust account.
Shifting your child’s investment strategy
If the unearned income from a child’s investment portfolio is triggering Kiddie Tax, you might consider adjusting your investment strategy. Stocks and bonds generate dividend and interest income that is taxable under the Kiddie Tax law. Investment yield refers to the income earned on your investment. This yield can be adjusted by changing the asset allocation of your child’s portfolio. By adjusting your child’s investment portfolio to a strategy of growth rather than income production, you can reduce unearned income subject to Kiddie Tax.
Deferring the realization of capital appreciation until a child is out of the Kiddie Tax age range is another option. An all-stock portfolio has historically appreciated at about 6.5% over inflation. The portion of growth which is not dividend yield will experience capital appreciation that can be deferred into the future. We recommend consulting your investment advisor to determine the portfolio mix that is most suitable to your situation.
Put that kid to work!
As a child’s earned income is not subject to the Kiddie Tax, having your older children work for the family business is an effective strategy. The child can contribute up to $19,000 (in 2019) in the company Roth 401(k) and an additional $6,000 in a Roth IRA, effectively sheltering up to $25,000 per year from all future taxes. In addition, if the child has savings in a taxable investment account, that money can be used as spending money in order to save as much of the earned income as possible. Spending investment account funds are one way to reduce unearned income and the resulting Kiddie Tax.
Kids Receiving Military Survivor Benefits
The TCJA is hurting some children receiving military survivor benefits. The Congressional Research Service (CRS) issued a new report suggesting ways to fix that. The TCJA changed the calculation of kiddie tax on certain military survivor benefits. Retired service members and dependents of service members who die while in active service can elect to provide their families with up to 55% of their pension after their death. The tax on these payments generally increased under the TCJA. The CRS suggests legislative options to prevent a child’s benefits from being taxed at rates higher than they used to be.
Beginning in 2018, the parents’ tax rate will no longer matter when calculating tax on a child’s unearned income. Instead, trust and estate tax rate schedules will be applied to a child’s unearned income exceeding $2,200. While this simpler form of taxation may result in higher tax liability, with proper planning it doesn’t have to. Consult with your tax advisor to determine the best way to reduce or eliminate your child’s Kiddie Tax burden.
The tax professionals at LBMC can help minimize the tax burden and provide crucial information on an ongoing basis to assist in day-to-day operations. Contact us to learn more about your specific tax situation.
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LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.