By Mae Hung, CPA
Taxpayers who make gifts to children or grandchildren believing that, by doing so, they can shift their income into a lower tax bracket may actually be inadvertently setting themselves up to get hit with an often hidden tax known as the “kiddie tax.”
The kiddie tax is not actually a separate tax but rather an income threshold above which a child’s unearned income (i.e. interest, dividends, and capital gains) is taxed at his or her parent’s marginal tax rate instead of at the child’s rate.
What are the Parameters of a “Kiddie”?
For kiddie tax purposes, a child is anyone under age 19 or any full-time college student under the age of 24. Previously, the kiddie tax applied only to children under age 14 but Congress increased the age limit to make it harder for parents and grandparents to reduce taxes by shifting income.
The first $1,050 of a child’s unearned income is tax-free and the next $1,050 is taxed at the child’s marginal rate. All unearned income above $2,100 is then taxed at the parent’s marginal rate, which could be as high as 39.6%.
Let’s assume you own stock that has appreciated by $10,000 and want to give this to your 16-year-old son. Upon selling that stock, assuming your son doesn’t have any other unearned income, only $2,100 of the taxable gain would be taxed at his marginal rate. The remaining $7,900 would be taxed at your marginal rate.
Some Strategies to Avoid this Tax
There’s a possible way to skirt the kiddie tax, particularly if your child or grandchild is in college. If he or she earns income via a wage or salary that provides more than half of his or her support, he or she might not be treated as a dependent. Further, there may be some additional income tax benefits related to tuition, because your child may be able to claim a deduction or credit that you can’t.
If you want to help pay your child’s or grandchild’s college tuition, another strategy would be to make tuition payments directly to the school instead of gifting assets directly to your young relative. In this case, your payment wouldn’t be subject to gift tax.
If your child has only unearned income totaling less than $10,500 (for 2016), as their parent, you may be able to include this on your tax return and not file a separate return for the child.
The details involved in planning gifting strategies to avoid the kiddie tax can be complex so if you’re planning on making a gift to a child in your life who fits the above criteria, it’s best to contact your Untracht Early tax advisor to discuss your particular situation.