Brush Up on the Kiddie Tax Before Helping Young Ones Invest

Question: I plan to open brokerage accounts for each of my children to give them a chance to learn about investing. If the accounts are in their names but they are minors, who pays the taxes?

Answer: Teaching your kids about investing by helping them try it for themselves is a great idea, but unfortunately the tax implications aren't quite so straightforward. 

One of the simplest ways to introduce your children to investing is to open an individual retirement account (IRA) in each of their names. This requires that they have earned income of their own--such as from a part-time or summer job--and the amount contributed to the IRA each year cannot exceed what they earned. Getting your kids to direct some of their hard-earned wages toward a long-term goal such as retirement may require an incentive; so, unless you plan to give them the money outright to start investing, you could offer to match IRA contributions they make on a dollar-for-dollar or some other basis.

For young retirement savers, a Roth IRA is often a better choice than a traditional deductible IRA because their tax rate will likely be higher when they retire, and paying lower taxes now beats paying higher taxes later. Plus, Roth contributions (but not earnings) can be withdrawn tax-free prior to retirement; so, if your kids decide they want to use some of the money for another purpose later on--such as to help pay for college--that is an option.

The Ins and Outs of Custodial Accounts
If opening an IRA isn't possible, your next decision is whether you do, indeed, want the accounts to be in your children's names. Doing so can lead to some tax savings--especially for children from high-income families--but there are potential downsides as well. We'll explore these pros and cons in a moment, but first let's talk about how custodial accounts work.

Many brokerages and fund companies offer custodial accounts (sometimes referred to as UGMA or UTMA accounts) as a way to establish ownership of assets on behalf of a minor while control over the account remains with an adult, such as a parent or guardian. It is extremely important to understand that once assets are placed in a custodial account they are legally the property of the beneficiary, and this change of ownership is irrevocable. It also means that once the beneficiary turns age 18 or 21 (depending on the state) he or she can assume control of the assets to do with as he or she sees fit.

Also, keep in mind that there are college-planning implications associated with UGMA and UTMA accounts. Because custodial assets are considered the property of the child, and because student-owned assets are penalized more heavily than parent-owned assets in need-based financial-aid calculations, your child might receive less financial aid for college than he or she otherwise would if the assets were to remain in your name, even if you're not planning to use these assets to help pay for college. (For more on these and other pitfalls, read Don't Let an UGMA Leave You Saying 'Ugh.')

In addition, be aware that the annual gift-tax exclusion currently is $14,000. So, if you plan to contribute more than that amount to your children's custodial accounts in a given year, it could have an impact on your estate taxes down the road (although this is really only of concern to high net-worth investors).

The Ins and Outs of the Kiddie Tax
Whatever the size of your children's custodial accounts, it's important to understand the tax advantages and their limits. One advantage of custodial accounts is that some unearned income (in other words, income that isn't from working) held in your child's name--such as dividends, interest, and capital gains distributions--is taxed at a lower rate than the parents pay, or not taxed at all. However, anything above that amount is subject to something known affectionately (well, maybe not that affectionately) as the "kiddie tax."

To ensure that wealthy families don't sock away investments in their children's names in order to pay a lower federal tax rate, special rules were put into place in the mid-1980s. Under these rules the first $1,000 of unearned income in the child's name is untaxed and the next $1,000 is taxed at the child's rate. Any unearned income above this level is taxed at the parent's rate (or the child's if it is higher).

The kiddie-tax system maintains the same special treatment of long-term capital gains and qualified dividends that would apply to an adult taxpayer, says Jackie Perlman, principal tax research analyst at The Tax Institute. That means that for the second $1,000 of unearned income, any long-term capital gains are taxed at whatever rate applies to the child while for any long-term capital gains above the $2,000 threshold, the parents' long-term capital gains rate applies. Based on this year's tax brackets, a child would need to have at least $36,900 in ordinary income to owe any tax on long-term capital gains or qualified dividends for the second $1,000, and his or her parents would need to have at least $73,800 (if filing jointly, or $36,900 for a single parent) in ordinary income for the child to owe anything after that. For short-term capital gains (those for sales of securities owned for less than a year) and nonqualified dividends, the child's ordinary income rate applies for the second $1,000 and the parents' ordinary income rate applies after that.

As an example, let's consider a child who does not make enough to owe any taxes on long-term capital gains but whose parents make enough to require them to pay a 15% tax on such gains. If the child has $2,500 in unearned income (we'll assume it's all from long-term capital gains), he or she pays no taxes on the first $1,000 and no taxes on the next $1,000 but a 15% rate on the remaining $500. So, effectively, out of that $2,500 in gains, the child would end up owing just $75 in taxes. (If the child also has earned income from a job, that is taxed separately and all of it is subject to the child's rate.)

If the child's unearned income totals less than $10,000, the amount may be included on the parents' tax return (using Form 8814); but if it is greater, a separate return must be filed. Including your child's unearned income on your tax return could reduce your ability to take advantage of some tax credits or deductions. So, if you are unsure how this will affect your tax situation, it might make sense to consult a tax professional.

The kiddie-tax rules apply through age 18, or through age 23 if the child is a full-time student. After that, the child files his or her own tax return and all of the individual's income, including unearned income, is subject to his or her tax rate--thus, ending the kiddie tax.

Potential Impact of the Kiddie Tax
Unless you plan to give your children a rather large sum to invest (or if you have a couple of budding young Warren Buffetts on your hands), the kiddie tax may not come into play for you, at least not for awhile. Interest and dividends alone may not produce enough income to carry your young investors above the $2,000 threshold at which they'd have to start paying taxes at your rate. To illustrate, a portfolio of stocks, bonds, or funds generating 5% in income annually would need to have $40,000 in it to reach that level.

Capital gains are another matter, however. A child who pays $5,000 for a stock in a custodial account and later sells it for $10,000 will owe taxes on the $5,000 in capital gains. The good news is that the first $2,000 of that gain may very well be tax-free, but the last $3,000 will be taxable at your rate.

Scenarios such as this are why some tax professional recommend selling out of the position gradually in order to stay within the $2,000-per-year threshold or holding on to appreciated assets until the child is no longer subject to the kiddie tax (assuming he or she will be in a lower capital gains tax bracket than you at that time). However, allowing tax considerations to be the main driver of your investing decisions isn't usually a great idea and probably isn't the primary lesson you're trying to get across to your kids either.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.