“Kiddie Tax” refers to special rules and taxes imposed on the unearned income of certain children. While the kiddie tax is nothing new, recent tax reform has completely revamped and simplified the way this tax is calculated for tax years 2018 through 2025. These new rules could drastically increase the amount of tax paid on investments made in your child’s name. It is important to understand this new legislation in order to make the most of any investments made for the benefit of your child.
Kiddie tax applies to any child whom:
- is required to file a tax return;
- does not file a joint return for the tax year;
- has investment income greater than $2,100 (for 2018);
- either of the child’s parents is alive at the end of the year; and
- is either: (a) under the age of 18; (b) under the age of 19 and does not provide more than half of his or her own support with earned income; or (c) under the age of 24, a full-time student, and does not provide more than half of his or her own support with earned income
Essentially, this taxed the child’s unearned income at the parent’s maximum marginal tax rate and was impacted by both the parent’s income and the income of any siblings also subject to the kiddie tax. Unearned income refers to interest, dividends, capital gains, and other investment income.
Recent tax reform has greatly simplified the calculation of kiddie tax. Beginning in 2018, tax on an applicable child’s unearned income will be calculated using the trust tax brackets. Thus, under the provision, the child’s tax is unaffected by the tax situation of the child’s parent or the unearned income of any siblings.
However, trust tax brackets reach their top marginal tax rates much quicker than individual tax brackets. For example, in 2018 a trust will reach the 37% bracket at only $12,500 of income whereas a married couple filing a joint return would not reach this tax bracket until $600,000 of income!
Therefore, the new kiddie tax rules will affect taxpayers very differently and must be considered when deciding how best to shift income from yourself to your child.
For higher income individuals already subject to 35-37% marginal tax rates, this legislation will have very little impact. Whether the portfolio is held by the parent or child, the income will be subject to relatively the same rate if it is in the maximum trust tax bracket. For lower and middle-income families, the impact could be more drastic. For example, for parents falling in the 22% tax bracket, historically the kiddie tax would have been computed at their 22% rate. Under the new legislation using the trust tax brackets instead, it will fall into a 24% tax bracket at just $2,550 of unearned income. The 35% and 37% tax brackets are reached at just $9,150 and $12,500 of unearned income, respectively.
If you have any questions about how the kiddie tax reform could affect your family’s investments, please do not hesitate to contact your L&B professional at (858) 558-9200.