The Tax Cuts and Jobs Act (TCJA) completely overhauled so many areas of our corporate and individual tax code that some of the smaller regulatory tweaks have been overlooked in their wake. The “kiddie tax” is one of those changes that slipped under the radar. As tax planning season approaches, it’s important to review even the smaller tweaks because they may affect taxpayers’ planning opportunities going into 2019. The kiddie tax, which is more formally known as “Tax on a Child’s Investment and Other Unearned Income,” is just as it sounds – a tax on children’s income. The unearned income of children, like dividends, interest, and capital gains, are taxed differently if the child’s unearned income exceeds a certain amount. Let’s look at how the TCJA has altered the kiddie tax rules.
Kiddie Tax Pre-TCJA
The kiddie tax applies to a child’s unearned income that exceeds $2,100. Prior to tax year 2018, unearned income that exceeded this threshold was taxed at the parents’ marginal tax rate rather than the child’s. The resulting tax was then allocated back to the child’s tax return. The IRS put this stipulation in place to prevent parents from shifting income-producing property like stocks and bonds to their children to take advantage of lower tax rates.
Kiddie Tax Post-TCJA
Post-TCJA, the kiddie tax threshold remains at $2,100. Beginning this year and going forward, however, a child’s unearned income that exceeds this threshold will be taxed at the rates that apply to trusts and estates.
The rate structure for trusts and estates is severely compressed compared to the individual tax brackets. See below for a comparison:
At first glance, this compressed rate structure for trusts and estates appears to be unfavorable to taxpayers. After all, unearned income of $10,000 would place the taxpayer in the 35% trust and estate tax bracket, but it would only place them in the 10% individual tax bracket. However, if we look a little closer, we can see that most taxpayers will save money under the new regime. Let’s look at an example of a middle-class family whose child has a small amount of unearned income:
Example 1: In 2017, Ron and Judy had taxable income of $125,000, which placed them in the 25% tax bracket. Their son, Adam, had $2,500 of taxable interest from a brokerage account. In 2017, the family would owe $625 of kiddie tax ($2,500 x 25%, the parents’ marginal tax rate).
In 2018, Adam earns $2,500 of taxable interest. Because this unearned income will be taxed using the trust and estate rates, this places him in the 10% tax bracket. In 2018, the family would owe $250 of kiddie tax ($2,500 x 10%, the applicable trust & estate tax).
As you can see, the kiddie tax for the same amount of income will be favorably taxed in 2018 compared to 2017. Even parents and children with higher earnings will come out on top. Let’s look at another example:
Example 2: In 2017, Jim and Kathy had taxable income of $450,000, which placed them in the 35% tax bracket. Their daughter, Ariel, had $18,000 of taxable interest from a brokerage account. In 2017, the family would owe $6,300 of kiddie tax ($18,000 x 35%, the parents’ marginal tax rate).
In 2018, Ariel earns $18,000 of taxable interest. Because this unearned income will be taxed using the trust and estate rates, this places her in the 37% tax bracket. In 2018, the family would owe $5,047 of kiddie tax (for information about how to calculate tax using a progressive system, click here).
This seemingly small tweak to the tax code can have a big impact for taxpayers, especially when finalizing their planning goals. Parents should closely monitor their children’s unearned income to avoid it being pushed into the highest trust and estate tax bracket. However, because the kiddie tax rules are potentially more favorable this year than in years past, there may be an opportunity for taxpayers to shift some high-performing assets to their children to take advantage of lower, more effective tax rates.
Parents should also consider the goals they have in mind for their children’s investment assets. Some parents use them as vehicles to save for college. This may be a viable strategy, but selling off those highly-appreciated assets will need to be planned out years in advance. Instead of selling the property in one fell swoop to pay for that first year at college, it may be wise to slowly divest of the assets as the child approaches college in order to avoid hefty kiddie tax bills. It may also encourage taxpayers to look into different college-saving vehicles, like 529 plans, rather than relying on brokerage accounts that are subject to the kiddie tax rules.
If you have any questions about the kiddie tax, or about how these changes will impact your existing tax plan, give your Spire professionals a call. We look forward to hearing from you!