Many higher income taxpayers have long made it a practice to open investment accounts for their children, hoping to take advantage of their lower tax rates. Many years ago, Congress imposed, what is colloquially known as the “kiddie tax” to place strict limits on the amount of investment income that can be taxed at those lower rates.
One of the changes made by the recently enacted Tax Cuts and Jobs Act of 2017 made some significant changes to how the “kiddie tax” is administered, impacting the way adults pass investment income on to their minor children.
The "kiddie tax" is a provision that taxes the unearned income of children under the age of 19 and of full-time students younger than 24 at a special rate. Under both the new law and the old, the first $1,050 of a child's income is tax-free and the next $1,050 is taxed at a rate of 10 percent.
The difference though begins when a child's unearned income goes above $2,100. Under the old law, this income was taxed at the parents' higher tax rate. However, starting in 2018 (and continuing through 2026, when the individual changes in the tax code expire), the amount above $2,100 is taxed at the same rate as income would be taxed in a trust. This represents a much harsher treatment of unearned income of dependent children.
Under this new regime, beginning 2018, a child's income from IRA distributions, interest and short-term gains will be taxed at the top federal rate of 37 percent once it exceeds $12,500. Comparatively speaking, the child’s married parents pay that rate of tax only on income above $600,000. The top long-term capital gains rate increases from 15 to 20 percent above $12,700 for a child, versus at $479,000 for the parents.
The “kiddie tax” changes will hit families of modest means; where the parents' tax bracket is lower, they will be hardest-hit, because the tax applies to all types of unearned income, provided a child has at least one parent still living. This means money a child receives from a legal settlement related to death of a parent or from Social Security survivor's benefits will be taxed at a much higher rate.
The “kiddie tax” rules allow distributions from an inherited IRA to be stretched out over the beneficiary's projected life span, providing potentially decades of tax deferral. For instance, a 17-year-old who inherited a $1 million IRA last year has 66 years to take the money and a 2018 required minimum distribution of $15,152. The federal tax on that (assuming the child has no other income) is $3,321, just $84 more than it would have been under the old “kiddie tax” rules (assuming the parents earn $250,000 a year).
The tax change will hit a child hard when large amounts of an inherited IRA are used to pay some type of expense. If a child withdraws $50,000 from a $1 million IRA to pay a large expense such as college or a new car, the federal tax bill will be $16,215. Under the old law, it would have been $11,601 if the child was taxed at the parents' rate.
Furthermore, the $50,000 withdrawal will not make the child financially independent because more than half the child’s support must come from earned income, not an inheritance or other unearned income.
Experts suggest these approaches to grandparents who are considering bequeathing an IRA to a grandchild:
- Name children or older, already established grandchildren as beneficiaries of traditional pretax IRAs.
- Young grandchildren can still be named as beneficiaries of Roth IRAs.
- Instead, fund 529 college savings plans now, because all 529 withdrawals used to pay for eligible higher-education expenses are free of federal and state income tax.
- Under the recent tax changes, up to $10,000 a year per child of money from a 529 account can be spent tax-free for K-12 private-school costs, provided your state allows it.
- If your child has already inherited a large IRA, have the child borrow as much as possible for college, and then repay the loans with IRA withdrawals once the child has graduated and is on his or her own, or has turned 24.
- Keep in mind that your child will likely still have to take annual required minimum distributions (RMD) from that IRA each year.
- Gift modest amounts of low-basis stock to Uniform Transfers to Minors Act (UTMA) accounts.
- On the first $14,800 in qualified dividends and long-term gains, a child will owe just $1,515, an effective 10 percent rate.
- Once stocks are sold, the cash can be transferred from the UTMA into a custodial 529 account.
For more information on changes in the “kiddie tax” law or to plan the best way to leave a traditional IRA to your grandchildren, please contact the Zinner & Co. tax professionals via email at email@example.com or by phone at 216-831-0733. We are happy to meet with you and come up with a plan that works best for everyone.