There was a time, years ago, when parents could substantially reduce their family’s overall tax burden by shifting income to children in lower tax brackets, usually by transferring investments or other income-producing assets. The Kiddie Tax, a product of the Tax Reform Act of 1986, was designed to discourage this strategy by taxing most of a dependent child’s unearned income at the parents’ marginal rate. The tax applies to children ages 18 or younger plus full-time students ages 19 to 23, with certain exceptions.
Under the Tax Cuts and Jobs Act, the Kiddie Tax is now imposed according to the tax rates applied to trust income. The trust tax brackets are compressed, so that the highest marginal rate kicks in when taxable income exceeds $12,500. In contrast, for a married couple filing jointly, the top bracket begins at $600,000 of taxable income. While the impact of this change will depend on a family’s particular circumstance it will generally reduce the cost of the Kiddie Tax for relatively small amounts of unearned income, but many families will find that the top Kiddie Tax rate is now higher than the parents’ marginal rate.
There are still opportunities to shift income within a family, according to Tamir Dardashtian, a tax principal at Top 100 Firm Anchin, Block & Anchin.
“The reason the Kiddie Tax came into being is to discourage shifting income to kids,” he said. “You could say that the changes under tax reform benefit or hurt people depending on what rates the parents are paying at the time.”
Dardashtian posed the possibility of using a trust to receive dividends because administrative expenses like accounting fees are no longer deductible on the individual level, but they are at the trust level. Then the trust distributes the qualified dividends to the child, who picks them up on their return, and there is an additional benefit with the new, higher standard deduction on the child’s return.
“There is still room for tax planning, especially for taxpayers whose objective in transferring assets to their children is not primarily tax-driven,” agreed Joyce Beebe, a fellow at Rice University’s Baker Institute for Public Policy.
“Under the current rules, the first $1,050 of a child’s unearned income is tax-free” she said. “The next $1,050 is taxed at a lower rate, usually the child’s own tax rate. The combined $2,100 threshold could still largely cover current annual dividends from a $100,000 investment in an S&P 500 index fund.”
“Another approach would be to focus on assets that are more likely to be Kiddie Tax-resistant," she said. “Examples include growth stocks and real estate holdings whose capital appreciation can be deferred until the child ages out of the Kiddie Tax, retirement assets that produce tax-free income such as a Roth IRA, and municipal bonds that generate interest that is excludable from gross income.”
Parents who are business owners can legitimately hire their older children, ages 18 to 24, to perform more complicated functions and pay them higher wages, generating earned income, Beebe noted. “The potential benefit of having greater earned income is that the child can get a higher or even full standard deduction. This benefit equally applies to cases where children have earned income from internships or other third-party jobs. If the child is a student, an additional benefit of having both earned and unearned income is that they may be able to claim certain education credits, such as the American Opportunity Tax Credit, and the Lifetime Learning Credit, that would reduce both their tax liability and alleviate the impact of the associated Kiddie Tax.”
