Form 8615As an advisor who works with clients in their 30s and 40s, I spend much of my time talking about children. Besides discussing how much fun kids are or how little their parents are sleeping, a majority of these conversations focus on the best way to save for children, now and for the future. We often discuss the pros and cons of 529 Savings Plans, custodial (UGMA/UTMA) accounts, and creating and funding separate trusts, as well as target annual savings rates for specific expenses (e.g. college, camp, etc.). One topic that is often overlooked, however, is the tax rules impacting accounts for minors.

Assets within 529 accounts are tax-free (if used for college) and are considered an asset of the adult, so they have no impact on a child’s tax return. The same goes for the Coverdell ESA, which offers tax-free investment and withdrawals if funds are used for qualified education expenses. However, custodial accounts, which are offered at virtually every bank and brokerage firm nationwide, are impacted by the aptly named “kiddie tax.”

Kiddie tax is assessed on a child’s unearned income – which  consists of interest, dividends, and capital gains – at the same rate as the child’s parents. This regulation was designed to discourage adults from shifting assets to their children in order to reduce their own tax rate. To the IRS, a child is:

  1. Under age 18,
  2. Under age 19 with earned income that amounts to less than half of his or her support, or
  3. A full-time student age 23 or under with earned income that amounts to less than half of his or her support.

There is a threshold for the kiddie tax, currently $2,100 per year. The first $1,050 of unearned income is tax-free and the second $1,050 is taxed at the child’s individual rate. This means that if a custodial account generates $4,000 of unearned income, $1,900 would be taxed at the parent’s rate, which in most circumstances is significantly higher than the child’s. One reason that our firm recommends using index funds within custodial accounts is because most are focused on growth rather than income and are traded much less frequently than individual stocks or actively-managed investments – ultimately resulting in a lower tax bill.

If a child’s unearned income surpasses the threshold, a Form 8615 needs to be attached to his or her  federal tax return.  Parents may instead elect to include their children’s unearned income (if less than $10,500) on their own tax return by filing a Form 8814.

Additionally, trust distributions to a child could be subject to kiddie tax if the trust is its own taxpayer. Distributions to a disabled child from a Qualified Disability Trust (QDT) are considered an exception to this rule.

If your child is subject to kiddie tax, you are likely doing a good job at saving for your child’s future. However, considering the tax implications of where you save and how you invest your kids’ money could result in more in their piggy banks at the end of the day.

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