Co–authored by Kristine M. Scott, Estate Planning Associate
Whether it’s to start your kids’ portfolio early, or provide income to students already in college, parents and grandparents make gifts to their children and grandchildren more than you may think. And if those children are under the age of 18, or over 18 but still considered a dependent, you should be aware of the “kiddie tax.”
What happens when the child receives interest, dividends, or capital gains (“unearned income”) during the year? Before the recent tax law change, a child’s unearned income was basically added to their parents’ taxable income to determine its tax liability, then allocated to the child’s tax return.
This meant that if your child’s investments and savings generated $15,000 in income last year, the $15,000 was added to your own income and taxed at your highest tax bracket.
For example, let’s say your ordinary income tax bracket was 25%. Assuming ordinary income rates apply, using your tax rate to calculate the tax on your child’s unearned income of $15,000 would generate roughly $3,750 in taxes. The $3,750 tax bill would then be added to your child’s tax return.
But last year’s tax law changed this – and not for the better in most cases.
The New Kiddie Tax
Under the modified kiddie tax, your child’s unearned income is no longer taxed at your bracket, but rather subjected to the income tax brackets applicable to trusts and estates. While this may seem irrelevant, the tax brackets for trusts and estates are extremely condensed, hitting the top tax rate of 37% for all income over $12,500.
This means that kids with unearned income of $12,500 or more may be taxed at 37% on the earnings even if their parents’ tax bracket is significantly lower. (Qualified dividends and capital gains are of course subject to special rules for both individuals and trusts/estates, but trusts/estates still hit the maximum tax bracket applicable to these types of income once the total income exceeds $12,500.)
Using the same example as above, a child that earns $15,000 of interest income this year would be paying $5,550 in taxes as a result of the interest. The impact for those children whose parents fall under the 37% tax bracket can be huge.
The good news is there is no longer a disincentive for parents to continue to exert some control over the gifts to their children by making the gifts in trust, since the earnings will be at the same rate whether the gifts are in trust or outright. There may also be other alternatives to an outright gift that will have more favorable tax consequences.
If you want to make a large gift to your child but now have questions on the best way to do so, give us a call at 904-807-2183. We can discuss the best avenue to provide funding in a tax efficient manner.