Updated: Feb 17, 2019
Our children are the most important legacy we leave behind. A huge part of estate planning is to ensure that our children are taken care of when we pass. Whether this is accomplished through wills, trusts, life insurance, IRAs, or other type of investment vehicles, our children are often the beneficiaries of our assets. While some vehicles might have zero tax consequences, other are penalized under the kiddie tax.
To understand the kiddie tax, let us start with an example. Assume Kip is 14. He earns $1,200 from mowing his neighbors' lawns during the summer months (imagine that Kip does not live Texas and that summer only lasts for 3 months). This is considered earned income. In addition to his $1,200 annual income, Kip also receives IRA distributions from his grandfather, interest from bonds his parents have purchased for him, and dividend from shares in his family's company. You guessed it, Kip makes way more than the tax attorney explaining this to you. The distributions, interest, and dividend Kip received are "unearned income." From the IRS's point of view, Kip didn't really earn that money, it was given to him by someone else. Another type of unearned income is capital gain. If Kip collects Magic the Gathering cards and sell them at a gain, then this too would be unearned income.
Why do these definitions matter?
While earned income is taxed under the rates for single individuals, net unearned income is taxed according to the brackets applicable to trusts and estates (a much higher rate). This higher rate is the kiddie tax.
Think about this. Husband and Wife make pretty good income. Let's say they have AGI of $609,000. At $600,000, they are taxed in the highest tax bracket. What if we were to shift $10,000 of that AGI to their son, who earns $1,200 a year? This would lower their AGI below $600,000 and into the lower bracket, and $10,000 if taxed at their son's rate would be much lower if at all. Of course it is much harder to shift earned income, child labor laws and all, so the parents will likely just shift unearned income to their son. Thus, all it took was some easy tax maneuvering.
Congress put a stop to this right away. Under the old rules, the child's unearned income would be added to the parents' income and both would then be taxed at the relevant rate. The TJCA changed this. The child's unearned income is still subjected to a higher tax rate. However, rather than adding it back to the parents' rates, the rates are calculated based on the following schedule.
See IRS Form 8615, Tax for Certain Children Who Have Unearned Income, and IRS Publication 929, Tax Rules for Children and Dependents, to assist in figuring out the complexities of the kiddie tax for the 2018 tax year.
You said "children." I know things are never as it seems for taxes, can you define it?
There are 5 requirements for the kiddie tax:
the child had not reached the age of 19 by the close of the tax year, or the child was a full-time student under the age of 24;
the child’s unearned income exceeded $2,100 (this is a limit that is set annually based on inflation and for 2018, the limit is set at $2,100);
at least one of the child's parents was alive at the end of the tax year;
the child is required to file a tax return for the tax year. This typically happens when there is more than $1050 of unearned income or $12,000 of earned income.
the child did not file a joint return.
Well I am not shifting my income to my children, why should I care?
The most common scenario where this occurs is through required minimum distribution (“RMD”) from a stretch IRA. The term "stretch" does not represent a specific type of IRA; rather it is a financial strategy that allows people to stretch out the life — and therefore the tax advantages — of an IRA. An IRA can be passed on from generation to generation while beneficiaries enjoy tax-deferred and/or tax-free growth. Back to our example, assume Kips grandfather had an IRA where Kip was the beneficiary. When Kip’s grandfather dies, the IRA policy is rolled into another, where Kip is the owner. Kip will then be required to take the minimum distribution based on his age and his expected life, or RMD. This distribution will then be subjected to the Kiddie tax. Thus, if Kip's RMD is over $12,500, he is subjected to the highest tax rate.
So what can I do?
Make sure you talk to your financial advisor to re-evaluate your financial plans. If a stretch-IRA is part of the plan, have the advisor run the numbers to ensure not too much RMD will be taken. If necessary, add another beneficiary to lower the amount of RMD.
If the IRA was designed to fund college tuition, consider funding a §529 (education) plan instead. For those students who are withdrawing funds for tuition, consider taking student loans until graduation or 24 years old, whichever is earlier. Once the student is outside of the Kiddie Tax window, withdrawals can then be used to pay back the student loans.
At Le Tax Law, PLLC, we’ll be with you every step of the way!
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