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Navigating the Kiddie Tax – After Tax Reform

You may have heard the term “kiddie tax” before. The “kiddie tax” rules prevent high-income taxpayers from shifting “unearned income” to their children or grandchildren in lower tax brackets. Children, in this case, refers to a child under age 19 at year-end, or under 24 years of age if they are in college and do not support more than 50% of their expenses. The term “unearned income” refers to income other than wages, self-employment business income, and similar amounts. Examples of unearned income include capital gains, dividends, and interest. Kiddie tax has caused children with investment income to be subject to income tax before, but the rates have significantly changed after tax reform.  

Before tax reform, children with unearned income were taxed at their parent’s marginal tax rate, assuming it was higher than their own rate. See below for the new kiddie tax rates. These rates are the same as the tax rates for trusts and estates.

  • up to $2,550 – 10%
  • $2,551 to $9,150 – 24%
  • $9,151 to $12,500 – 35%
  • all over $12,501 – 37%

Tax reform did not change who is subject to the kiddie tax, those rules remain the same.  But it has effectively increased the kiddie tax rate in most cases.

For 2018–2025, a child’s unearned income beyond the threshold ($2,200 for 2019) will be taxed according to the tax brackets used for trusts and estates. Planning Strategy:  try and reduce the unearned income to be under $2,200 so there is no income tax.

For ordinary income (such as interest and short-term capital gains), children are taxed at the highest marginal rate of 37% once the kid’s 2019 taxable income exceeds $12,750.   In contrast, for a married couple filing jointly, the highest rate doesn’t kick in until their 2019 taxable income tops $612,350. Based upon the new rates, it’s no longer beneficial to shift income to children as their tax rates oftentimes will be higher than their parent’s rates.

In addition, the 15% long-term capital gains rate begins to take effect at $78,750 for married filing jointly filers in 2019 but at only $2,650 for children. And the 20% rate kicks in at $488,850 and $12,950, respectively. It is no longer attractive to have a lot of capital gains allocated to children if the child’s taxable income exceeds $12,950.

One unintended and costly consequence of the TCJA kiddie tax change is that some children in Gold Star military families (i.e., parents were killed in the line of duty) are being assessed the kiddie tax on certain survivor benefits.  In some cases, this has more than tripled their tax bills because the law treats these benefits as unearned income!  Congress has recognized this is a problem and the U.S. Senate has already passed a bill to change the treatment of survivor benefits to be taxed as earned income.  Currently a companion tax bill in the U.S. House of Representatives is currently stalled preventing the tax law change.

Bottom line, children’s unearned income will be taxed at higher rates than their parents’ income in many cases. Therefore income shifting to children subject to the kiddie tax may no longer save income tax, but it could actually increase the overall tax liability.

It is important to plan ahead.  When transferring assets to children (as part of a plan to reduce the overall family’s income taxes), be sure to consider the kiddie tax before transferring income-producing or highly appreciated assets to a child or grandchild. It makes more sense to transfer assets to adult children or grandchildren no longer subject to the kiddie tax but in a lower tax bracket.  If your child or grandchild has significant unearned income, contact us to identify possible strategies that will help reduce the kiddie tax for 2019 and later years.

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