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It may be time for clients to rethink their children's investments

When the Tax Cuts and Jobs Act was signed into law in December 2017, very few people were paying attention to how it would affect the so-called kiddie tax on children’s investments and unearned income.

Before the sweeping reforms, children under 18 and full-time students under 24 were taxed on their investment or other unearned income at the same rate as their parents.

In short, under the old law, two children who made the exact same amount in portfolio, investment or unearned income could be taxed differently depending on what income bracket their parents fell into. A child whose parents made $100,000 that year, for example, would be taxed at a significantly lower rate than a child whose parents made $800,000.

At first glance, the old system may have seemed unfair, but it helped ensure that children in lower-income families receiving income from investment accounts set up by a grandparent, legal settlements or even social security, would be taxed at a rate that matched their parents’ less affluent salaries. It also prevented high-net-worth parents and grandparents from avoiding having to pay tax at a higher income bracket when it came to their children’s investments.

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In an effort to simplify tax law, the TCJA changed the rules around the “kiddie tax.” Although most advisors would agree the bill did just that, in some situations, it may result in children being taxed at a higher rate than their parents.

The new rules disregard the income of parents or siblings, putting into place blanket rules for investment earnings of more than $2,100. Under the new law, a child earning up to $2,550 will be taxed at 10%, a child earning between $2,500 and $9,150 will be taxed at 24%, a child earning between $9,150 and $12,500 will be taxed at 35%, and a child earning more than $12,500 will be taxed at 37%. This means that children in the top bracket whose parents make less than $600,000 when joint filing are going to be subject to higher taxes than their parents.

Perhaps an example will help illustrate this:

Geoffrey (age 17) has $2,000 of earned income from working part time as a little league umpire and $16,000 of unearned ordinary income from his “portfolio.” His standard deduction is $2,350 ($2,000 of earned income + $350).

Geoffrey’s taxable income is $15,650 ($2,000 + $16,000 - $2,350). The $15,650 is treated as unearned income, as his $2,350 standard deduction offsets all his earned income, plus the first $350 of his unearned income.

The first $2,100 of a child’s unearned income will not be taxed according to the tax brackets used for trusts and estates.

The remaining $13,550 of taxable income ($15,650 - $2,100) is subject to kiddie tax rules and, thus, taxed at the rates for trusts and estates:

  • The first $2,550 is taxed at 10%, resulting in $255 of tax.
  • The next $6,600 ($9,150 - $2,550) is taxed at 24%, resulting in $1,584 of tax.
  • The next $3,350 ($12,500 - $9,150) is taxed at 35%, resulting in $1,172.50 of tax.
  • The remaining $1,050 ($13,550 - $12,500) is taxed at 37%, resulting in $388.50 of tax.
  • So Geoffrey’s tax bill is $3,400 ($255 + $1,584 + $1,172.50 + $388.50).

If Geoffrey’s parents’ marginal tax bracket is lower than 37%, they could be paying less than their child on the same income.
What this means for a family depends largely on the financial situation, but the new rules are important to consider when creating or maintaining a child’s investment account. After all, taxes have a significant impact on investment returns and the management of an investment portfolio, and because after-tax performance is what really matters when investing, even a marginal shift in tax rates could result in more or less money for a child to use in the future.

Under this new normal, it may be prudent to re-evaluate a child’s investments. Putting more money into 529 college savings plan accounts may be the right move in light of these new rules, though, these accounts inherently have less flexibility than their custodial counterparts.

All parents want their children to succeed, and setting up investment accounts is a good way to ensure that their financial future is secure. Although these changes to the laws may complicate things a bit for parents, putting a little extra thought into where a child’s money is going is never a bad thing.

This story is part of a 30-30 series on tax-advantaged investing.

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