The Ins and Outs of Kiddie Tax Rules

Question:

I really want to teach my daughter about how investing works and let her see the magic of compounding for herself. She has picked out a stock she wants to buy--

Answer: I applaud your efforts to teach your daughter about investing. Financial literacy is often an area that doesn't get enough attention in schools, so teaching it at home is a wonderful and worthwhile idea. But as you alluded in your question, the tax implications of having investments in your child's name can be complicated.

How the Kiddie Tax Works The "kiddie tax" rules became part of the tax code in the 1980s as a way to ensure that parents were not using their children as tax shelters. In other words, because children earn less income than their parents and are consequently in a lower tax bracket, there is an incentive to shift investment income away from someone in a higher tax bracket (the parents) to someone in a lower tax bracket (the children), in order to pay a lower federal tax rate on the unearned income. (Unearned income consists of dividends, interest, and capital gains distributions from investments.)

There is some leniency to the rules, however. Per the IRS, the first $1,050 of unearned income in the child's name is untaxed and the next $1,050 is taxed at the child's rate. Any unearned income above this level is taxed at the parent's rate (or the child's rate if it's higher).

Further, the same preferential tax rate for long-term capital gains and qualified dividends that applies to adults also applies to kids. As a reminder, long-term capital gains and qualified dividends are taxed at 0% for those who are in the 10% or 15% tax brackets. This means that anyone--adult or child--who has less than $37,950 in ordinary income would not pay taxes on the first $2,100 in investment income.

For any long-term capital gains above the $2,100 threshold, however, the parents' long-term capital gains rate applies. So, if the parents had at least $75,900 (if filing jointly, or $37,950 for a single parent) in ordinary income, the tax rate would be 15% (or 20% for parents in the highest tax bracket) after that initial $2,100.

For short-term capital gains (on sales of securities owned for less than a year) and nonqualified dividends, the child's ordinary income tax rate applies for amounts over $1,050 but below $2,100, and the parents' ordinary income tax rate applies after $2,100.

Let's consider this scenario: A child has $3,000 in unearned income. He does not make enough to owe any taxes on long-term capital gains, but his parents make enough to require them to pay a 15% tax on such gains. If the $3,000 is all from long-term capital gains, the child pays no taxes on the first $1,050 and no taxes on the next $1,050, but he pays taxes at a 15% rate on the remaining $900. So out of that $3,000 in gains, the child would end up owing $135 in taxes. (If he also has earned income from a job, that is taxed separately and all of it is subject to the child's rate.)

Alternatively, if the child's unearned income totals less than $10,500, the amount may be included on the parents' tax return (using Form 8814) instead of filing a separate tax return for the child. Per the IRS, however, including your child's unearned income on your tax return could result in you paying more in taxes, and it could reduce your ability to take advantage of some tax credits or deductions. (See Page 10 of IRS Publication 929 for more.) If the unearned income is greater than $10,500, a separate return must be filed.

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 own tax return and all of his income, including unearned income, is subject to his tax rate--thus ending the kiddie tax.

What Type of Account Should You Open for Your Child? Before we get too far into the weeds, it's worth noting that the kiddie tax is a nonissue for IRAs. It only comes into play for taxable and UGMA/UTMA accounts.

IRAs That said, one option is to open an individual retirement account in your child's name. Some brokerages such as Schwab and Fidelity offer custodial IRAs with no fees and a low or no minimum balance. To do this, your child has to have earned income (from some type of job), and the amount contributed to the IRA each year cannot exceed what she earned (or a maximum of $5,500). There are two types of IRAs that kids could use: traditional and Roth. The difference between them comes down to when the money is taxed; for traditional, the money compounds on a tax-deferred basis year in and year out, and the contributions and earnings are taxed when the money is withdrawn in retirement (age 59 1/2). Roth IRAs are funded with aftertax dollars, and withdrawals, including any earned income, are tax-free after age 59 1/2.

For young retirement savers, a Roth IRA is a better choice than a traditional deductible IRA because the tax rate for young savers will likely be lower now than it will be in retirement. Plus, Roth contributions (but not earnings) can be withdrawn tax-free prior to retirement, which means kids can use some of the money for another purpose, such as paying for college. Also, you can withdraw up to $10,000 from your investment earnings penalty- and tax-free if you use it for a downpayment on a home.

And, unlike a custodial account such as a UGMA or UTMA, traditional or Roth IRAs do not factor into the expected family contribution equation when determining how much financial aid your child is eligible for. (Be aware however that any withdrawals you make to help pay for college, though penalty-free when used for qualified educational expenses, will be counted as income in the EFC calculation and could lower the amount of financial aid received in the following year.)

Custodial Accounts If opening an IRA isn't possible, but you really want the assets to be in your child's name, many brokerages and fund companies offer custodial accounts. Sometimes referred to as UGMA or UTMA accounts, these accounts are 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. However, once assets are placed in a custodial account they are legally (and irrevocably) the property of the beneficiary. Also, 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.

Note that UGMAs and UTMAs also have a larger impact on college financial aid eligibility than IRAs. 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 (20% versus 5.64%, respectively), your child might receive less financial aid for college than he 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 UGMA and UTMA custodial accounts, see this article.)

Potential Impact of the Kiddie Tax The good news is that there's a good chance that kiddie tax rules may not even come into play for you. Unless you plan to give your children a rather large sum to invest, interest and dividends alone may not produce enough income to carry your young investor above the $2,100 threshold at which she'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 $42,000 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 $2,100 of that gain may very well be tax-free, but the last $2,900 will be taxable at your rate.

Scenarios such as this are why some tax professionals recommend selling out of the position gradually in order to stay within the $2,100-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 are at that time).

But allowing tax considerations to be the main driver of your investing decisions isn't usually a great idea and probably isn't the main lesson you're trying to teach to your kids, either. As you said in your question, learning how investing works and seeing the magic of compounding firsthand are the most valuable takeaways here.