New Baby Tax Benefits

By Sara Palovick

When you shop for a gift for a baby, consider a custodial account, tuition savings plan, a trust or other gifting strategy designed to help the families of newborns minimize taxes.

TAX BENEFIT

Open a custodial account for the baby under your state’s Uniform Gifts or Transfers to Minors Acts using the baby’s Social Security number. Income from the account is taxed at the baby’s rates. The minor must be given complete access to the money by age 18 or 21, depending on state law. A parent is generally the custodian. For 2012, children under the age of 18 (or under 24 if a full-time student) can earn $950 of investment income free of tax. An additional $950 of investment income will be taxed at 10%. Investment earnings over $1,900 are taxed at the parents’ rate.

TAX BENEFIT

Open a Section 529 qualified tuition savings plan. Annual contributions up to $13,000 ($26,000 with a consenting spouse) are gift tax free. A special rule for 529 plans allows an election to spread a one-time transfer over five years for gift tax purposes, so initial contributions of up to $65,000 or $130,000 are permitted. Some states allow tax deductions for contributions. When the funds are used for college tuition, the income is completely tax free. Income included in withdrawals not used to pay college tuition is subject to income tax and a 10% penalty. If the designated child beneficiary does not attend college, the beneficiary can be switched to someone who uses the money to pay tuition.

TAX BENEFIT

Report U.S. savings bond interest annually by making an election on a child’s first return rather than letting income taxation be deferred. File the tax return even though it is not required to make the election. Reason: The baby will owe no tax as long as the interest accrued on the bond does not exceed $950 a year, including any other unearned income the child might have. When the child eventually cashes in the bond, no tax will be due.

TAX BENEFIT

Set up a trust for the baby. Trusts provide greater control over the funds than a custodial account and funds can be kept in the trust long after the child turns age 21. Trustees can also make distributions contingent upon certain events, such as attending college or a summer vacation trip overseas. See your attorney for more information.

TAX BENEFIT

Buy additional life insurance on the parent. Have the policy owned by a trust to prevent the proceeds from being included in either parent’s taxable estate and to provide asset protection for the proceeds. Set up the trust to permit current income to the surviving spouse with principal eventually to the child.

TAX BENEFIT

Shift future income to the child by transferring assets that produce little current income with future growth potential into a trust. The appreciation will be taxed at the child’s lower rates when age 18 or older and will not be included in the donor’s eventual estate.

TAX BENEFIT

Buy tax-favored investments in the baby’s name, such as municipal bonds paying tax exempt interest, or stock index funds or growth stocks that pay low dividends. These investments are suitable until the child is no longer subject to kiddie tax.

There are also nontax reasons that should be considered, such as the effect on the child having control over large sums when he or she reaches majority or is on college assistance. Taxes are part of family financial planning, not the be all and end all.