One of the outcomes of the Tax Cuts and Jobs Act is that children with unearned income may find themselves in a higher tax bracket than their parents. This is because, under the “kiddie tax,” as it’s sometimes referred to, a child’s unearned income is taxed according to the tax brackets for trusts and estates, under which the highest tax rates kick in at far lower income levels. The good news is that there are strategies to allow for family income shifting.
Origins of the kiddie tax
Transferring investments and other income-producing assets to your children can be an effective estate-planning technique. Not only are the assets removed from your taxable estate, but any income they generate is taxed at your child’s presumably lower tax rate.
The Tax Reform Act of 1986 introduced the kiddie tax to recover this lost tax revenue. If the kiddie tax applies, a child’s unearned income above a specified threshold (currently, $2,200) is taxed at the kiddie tax rate (originally, the parents’ marginal rate; now, the trust and estate rate) — assuming it results in a higher tax than the child would pay without the kiddie tax.
Originally, the kiddie tax applied to children under 14, but in 2007 Congress expanded the tax to include all children age 18 or younger, plus full-time students age 19 to 23.
Kiddie tax in action
Before the TCJA, the kiddie tax simply erased the benefits of income shifting. But in its current form, the tax can often be punitive. For example: Mike and Julie are a married couple filing jointly with taxable income of $300,000 per year. They transfer several investments to their 18-year-old son, Nick, which generates $20,000 in taxable interest income annually. If the kiddie tax didn’t apply (and assuming his total taxable income is less than $38,700), Nick would be in the 12% tax bracket. Under the pre-TCJA kiddie tax rules, and using the current brackets, Nick’s unearned income would be taxed at Mike and Julie’s marginal rate of 24%. But under the current version of the kiddie tax rules, which apply the estate and trust brackets, most of Nick’s income is taxed at 35% or 37%.
There are several potential strategies for avoiding the kiddie tax while still taking advantage of income-shifting benefits. They include:
- Delaying investment income. The kiddie tax ceases to apply in the year your child turns age 19 (24 for a full-time student). So, you can avoid kiddie tax by delaying investment income until your child reaches the applicable age.
- Using tax-exempt investments. Income on tax-exempt municipal bonds or bond funds is exempt from all income taxes, including the kiddie tax.
- Increasing earned income. Remember, the kiddie tax applies only to unearned income. Income your child earns from a job is taxed at the child’s tax rate, and earnings up to the standard deduction (currently, $12,200) are tax-free. Plus, if your child is 18 or older and has enough earned income to cover more than half of his or her living expenses, the kiddie tax doesn’t apply to any of the child’s income, earned or unearned.
If you own a business, consider hiring your child. Doing so increases the child’s earned income and, so long as the wages are reasonable, your business gets a deduction. And if your child is under 18 and your business is unincorporated, this strategy avoids payroll taxes on your child’s wages and reduces self-employment taxes.
This isn’t child’s play
Shifting income to your children is an option to reduce your tax bill. However, before doing so, look closely at the kiddie tax before you attempt this strategy. Our Family Wealth and Individual Tax Group can help answer your questions.