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Big changes for the ‘kiddie tax’ in 2018

Paul Pahoresky

July 21, 2018

One of the many tax law changes with the recent Tax Cuts and Jobs Act that many of us did not initially catch is the significant changes in the so called “kiddie tax.”

This is a tax that applies to investment income of dependents up to age 18 and even up to 23.

For tax years between 2018 and 2025, kiddie tax rates will no longer be at the parents’ marginal rates. The parents’ rates will no longer matter, but rather a child’s investment earnings in excess of $2,100 will be taxed at trust and estate tax rates.

The kiddie tax can trace its origins back to the Tax Reform Act of 1986.

The provision is intended to eliminate the practice of shifting investment income from higher tax bracket parent rates to lower tax rates on their children. The government was trying to close up a loophole that was used to avoid taxes on investment income.

The initial law has gone through several refinements and now covers dependents up to age 18 and extends to dependents age 23 if they are full-time students.

Although many people think that this tax only applies to high net worth families, many families that are saving for future college costs could be impacted if they do not plan appropriately.

The new tax laws simplify some of the complexity involved in the proper calculation of the taxes, but potentially substantially increase the corresponding tax rates. The computations under the new law no longer take into consideration the tax situation of the child’s parents or the unearned income of other siblings. Previously these items factored into the calculations making it impossible to file the child’s return until the parents and other siblings’ returns were completed as well.

Under the new laws enacted for 2018 through 2025, the parents tax situation and tax rates no longer apply.

The new tax rates on investment earnings of dependent children in excess of $2,100 will be taxed at the following rates: up to $2,550 taxed at 10 percent; from $2,550 to $9,150 taxed at 24 percent; from $9,150 to $12,500 taxed at 35 percent, and over $12,500 taxed at 37 percent.

As a result of these changes the new tax rates could for the kiddie tax could be higher or lower than the parent’s tax rate, depending on the amount of the child’s investment income and the parents’ rate.

These tax changes increase the need for planning, especially when it comes to saving for college. If you were planning on using accounts that are in the child’s name you need to pay careful attention to the amount of unearned income to avoid paying the 35 percent or 37 percent rates.

If you have significant unrealized capital gains that will become realized because of necessary security sales to fund the college tuition bill you need to plan appropriately to reduce the capital gains rates to the lowest rates. You may want to even consider gifting between a parent and child to take advantage of the lowest capital gains rates possible.

In either case, you don’t want to wait to begin this planning process when the student is in college.

You may need to begin taking steps in high school or even middle school to take advantage of the 0 percent rate on capital gains that is available if you plan appropriately in the years before college begins. If you have appreciated stock, if you plan and schedule the dispositions appropriately you could reduce the corresponding capital gains rate from as high as 23.8 percent down to 0.

The need to plan increases as tax laws are changed. Although the kiddie tax laws are simplified the impact on the child’s tax liability has been significantly impacted. Understanding these changes and planning accordingly will help to minimize the corresponding tax liability.

   

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