Congratulations, you’re a new parent! If you’re reading this then you’re probably in the midst of googling everything you need to know about how to be a good parent. What’s the best baby food? What diapers should I buy? How much sleep do new parents need?
At this point, you’re probably realizing how costly it is to have a child. Not only do you have to support their current needs but you also have to think about their future needs as well. When should I save for college? What are the best schools in my area? How do I make sure my kid is cool? Investing in your child’s future is not only important but it’s also critical for their future success.
However, with the new tax law changes in 2018 parents should consider their investment options before making any rash decisions. No matter how well-intentioned, choosing the wrong investment option for your newborn can have many unintended tax consequences.
The Tax Cuts and Jobs Act (TCJA) passed back in December of 2017 made substantial changes in the tax code. Specifically, the TCJA effectively eliminated the complexities of the “Kiddie Tax”.
Just for some quick background, the origins of the Kiddie Tax can be traced back to The Tax Reform Act of 1986, often referred to as the second of the two “Reagan tax cuts”. The provision was intended to close a loophole in the tax code that allowed high net worth individuals to shift income to their children – the thought being that unearned income (i.e. capital gains and qualified dividends) would be taxed at a lower rate on the child’s tax return.
For example, John Richman, as his name suggests, finds himself in the highest tax bracket and is subject to the 20% maximum capital gains rate. John has realized capital gains of $100,000 in the current year and faces a potential tax liability of $20,000. John thinks to himself, “If I split this income among my 4 children then I could reap some real tax savings”. Since the kids fall in the 0% long term capital gains tax bracket, they would presumably pay no income tax on their capital gains!
For obvious reasons, Congress wanted to close this loophole by requiring young children to pay tax on unearned income at the same rates as their parents. In 2006 and 2007, Congress expanded the “Kiddie Tax” provisions to cover dependents up to age 18 and even to age 23 if they are full-time students.
However well-intentioned, closing this loophole added more complexity to an already complex tax code. More and more families fell under the rules which made it costlier to file a family’s tax returns.
In an attempt to simplify the Kiddie Tax rules and reduce the compliance cost for families, the TCJA effectively decoupled children’s returns from their parents. For this upcoming tax year dependents will no longer pay tax on net unearned income at their parent’s rates. Instead, net unearned income reported on a dependents return will be taxed according to brackets applicable to trust and estates.
This is an important distinction because these brackets are much steeper and much narrower than individual tax brackets. For example, in 2018 the top bracket for trust and estates on ordinary income is 39.6% which starts at $12,501 – the top rate for individuals is 37% on ordinary income above $500,000.
Even unearned investment income like long term capital gains and qualified dividends isn’t spared from the steep rate structure. The top rate for trust and estates for preferential income items sits at 20% on income above $12,700. This top rate isn’t reached until an individual earns in excess of $425,800 on this type of income.
Although you may want to give your child a head-start when it comes to investing, doing so might result in some unintended tax consequences.
Reporting unearned income on your child’s tax return in 2018 could result in a higher tax rate and therefore more tax paid than in previous years. This is especially true for taxpayers who themselves don’t reach the top tax bracket.
To avoid this tax penalty parents should be smart about their investment options. The following are some suggestions to avoid the Kiddie Tax this tax season while securing their child’s financial future.
Election to Report Child’s Interest and Dividends on Parent’s Return – You may be able to avoid the kiddie tax by electing to report your child’s interest, ordinary dividends, and capital gains distributions on your return. Your child must be under the age of 19 (or under 24 if full-time student) has gross income of less than $10,500 and only had income from interest and dividends (including capital gain distributions and Alaska Permanent Fund dividends). If you make the election by attaching Form 8814 to your return then your child isn’t required to file a return.
Investing in a 529 Plan – a 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. Higher education is getting increasingly expensive so saving for your child’s college fund in a tax effective 529 plan will ensure their future financial success.
Roth IRA – if you have a family owned business and working aged children then you can give their retirement a jump-start by allowing them to contribute to a Roth IRA. In order for someone to contribute to a Roth IRA, they need earned income. By giving them a summer job and putting those wages in a Roth IRA you could grow your child’s retirement account while teaching them the value of hard work.
If the fallout of the new tax law has taught us anything it’s that seeking tax and financial advice from qualified trusted advisors is more important than ever. Having an accountant and financial advisor review your investments is important for 2018 to avoid the Kidde Tax and ensure your child’s future financial success.
Author: Jeremias Ramos, CPA | firstname.lastname@example.org