Several years ago, we wrote an article about the Kiddie Tax. The recent Tax Cuts and Jobs Act of 2017 (TCJA) requires we post a Kiddie Tax update.
The Kiddie Tax is applied to the unearned income of children under age 19 (or under 24 if a dependent full-time student). Before the Kiddie Tax was introduced in 1986, some wealthy parents sheltered investment income by transferring investment assets to their minor children. This practice shifted unearned income from the wealthy parents’ higher tax bracket to their child’s lower bracket. The Kiddie Tax was designed to limit the transfer of investment income by taxing unearned income over a small threshold (currently $2,100) at the parents’ marginal tax rate, not the child’s.
In 2018, unearned income under the $2,100 Kiddie Tax threshold will continue to be taxed at the child’s rate. However, as a result of the TCJA, unearned income exceeding this threshold will no longer be taxed at parents’ marginal rates but at the much more compressed tax rates of trusts and estates. The highest marginal bracket for personal taxpayers and trusts is 37%. However, a married couple’s taxable income must exceed $600,000 in 2018 to be taxed at this rate. The highest marginal tax bracket for trusts (and therefore the Kiddie Tax) begins at just over $12,500 of taxable income —quite a difference! As a result of TCJA, children may have a higher tax rate than their parents!
So do the new Kiddie Tax changes mean that Kiddie Tax rates will increase for every taxpayer?
Not necessarily. While the highest marginal rate for trusts begins at $12,500, the first $2,550 of income for trusts is taxed at 10%. This means that a child can receive up to $4,650 of unearned income before exceeding the 10% marginal rate ($2,100 Kiddie Tax threshold + $2,550 in the lowest trust tax bracket). The next $6,600 is taxed at the next trust tax bracket of 24%, which may also be lower than their parents’ marginal rate. In this scenario parents and their children could actually benefit from the TCJA.
Additionally, high-earning parents may not be adversely affected by the Kiddie Tax changes if they were already in the highest marginal tax bracket. In fact, they may see a small reduction in taxes as the highest marginal tax rates for married couples and for trusts dropped from 39.6% to 37%.
However, more modest-earning parents could see a significant increase in Kiddie Tax rates under the TCJA. For instance, consider a couple with $150,000 of taxable income. Before the TCJA, they were in the 25% tax bracket. Kiddie Taxes would have been applied at their 25% marginal rate—worse than their child’s tax rate, but much better than the highest marginal rate (39.6% pre-TCJA). While the TCJA reduced the parents’ tax bracket from 25% to 22%, the TCJA increased their child’s Kiddie Tax rate to 37%, the highest marginal rate for trusts. While their $150,000 of taxable income is well below $600,000 (the highest threshold for married filers), it is well above $12,500 (the highest threshold for trusts).
What planning should be done in light of the TCJA’s revision of the Kiddie Tax rules?
Make sure you understand how the new legislation will affect your family’s Kiddie Tax rate. If you have a custodial account for a child or grandchild, determine how much income it generates each year. Is the income limited to interest and dividends or does it include capital gains (gains are taxed differently than other unearned income, but still subject to the same low $12,500 trust income threshold)?
Consider shifting more assets and income to children if your family’s Kiddie Tax rate will decrease under the TCJA. If you are already in the top marginal Kiddie Tax rate, then you may want to curtail additional direct gifting to children.
Planning should never be done in a silo, and this article is not an all-encompassing income-shifting discussion. Wealth can be transferred to children in many ways, such as through 529 plans, direct payment of education and health-related expenses, or Roth IRAs, to name a few.
In summary, recent tax law changes should prompt many taxpayers to review their current wealth transfer plans. Some may find the new Kiddie Tax rules favorable, others, not so much. And remember, while the Kiddie Tax was enacted to limit income shifting, there could be other wealth transfer strategies appropriate for your specific situation. We recognize that strategies appropriate for one client may not be appropriate for others. Please call or come by to discuss planning for you and your family. As always, thank you for choosing Bragg Financial Advisors.
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.