Part of being an informed consumer of a college education is understanding some of the tax implications of certain situations in our lives. This is of particular interest to your clients that will not qualify for need based financial aid. Cutting the cost of college for these families often times comes in the form of “tax scholarships”.
For a long time, savvy families would funnel unearned income through their children to reduce overall tax liability. The kiddie tax was created in the 1980’s to prevent, or at least limit the benefit of holding investments in their children’s names by taxing amounts of children’s unearned income that is over a certain amount at an extremely high rate. The recent Tax Cuts and Jobs Act made significant changes to this Kiddie Tax beginning in 2018.
Who are “kids”?
The Kiddie Tax applies to children:
- Under 19 years old
- Dependent full-time students (for at least 5 months) between the ages of 19 and 23 (Dependent student’s earned income is less than half their annual expenses.)
- Does NOT include children who are married and filing a joint tax return
What is income?
The Kiddie Tax applies to:
- Unearned income a child receives
- Gifts, inheritances, cash, stocks, bonds, mutual funds, and real estate
- Salary/wages earned by the child is NOT subject to the tax
How did it used to be?
In 2017, a child was allowed $1,050 in untaxed unearned income. No taxes on the first $1,050. Easy start, but after that it gets more complicated. The second $1,050 was taxed at the child’s tax rate—probably a low rate and often 0%. The tax code provided a Long Term Capital gains rate of 0% for individuals in the 10% or 15% tax bracket. Once the unearned income reaches the $2,100 level, the parent’s tax rate comes into play on any amount in excess of $2,100. Unearned income above $2,100 was taxed at the parent’s highest earned income tax rate, which could be as high as 39.6%. If a parent had multiple children with unearned income, that income was added together to calculate the tax. Here’s an example:
Say a child had unearned income of $5,000. They would pay 0% of the first $2,100. Then on the remaining $2,900, they would pay $1,148 in taxes if the parent’s tax bracket was 39.6%. OUCH!
What’s new for 2018?
With the Tax Cuts and Jobs Act, the Kiddie tax has been simplified and will stay in effect until 2025. The rules on the first $2,100 of unearned income remain unchanged.
So, the first $2,100 of unearned income is not taxed. Amounts over the $2,100 threshold are taxed at the following rates:
- Up to $2,500 – 10%
- $2,551 to $9,150 – 24%
- $9,151 to $12,500 – 35%
- All over $12,501 – 37%
Children are no longer impacted by their parent’s tax rate plus parents don’t have to worry about adding the earnings of several siblings together.
The new rates could be higher than your client’s highest tax rate under the new tax code. A married couple would have to have over $600,000 in income to reach the highest Kiddie Tax rate of 37%.
Using our unearned income of $5,000 example again, the first $2,100 would be untaxed leaving $2,900 to pay taxes on. The tax would be 10% on the next $2,500 or $250 and then 24% on the remaining $400 or $96. As you can see, this is a huge difference in tax payments due. So, your client could have $4,600 in unearned income and only pay $250 in tax. Not a bad deal!
Impact of Kiddie Tax on planning for college
So where does this come into play? When your client gets their tuition bill of course! If they plan to utilize appreciated securities in an UGMA or UTMA account in the student’s name it would be wise to manage the capital gains each year. They need to pay careful attention to the unearned income during the year to avoid paying 35% or 37% tax rates.
If your client’s have appreciated stocks or mutual funds that they own and plan to use them for college costs they may want to consider gifting the security to the student first and have them liquidate the security. Utilize the students tax capacity at the 0 and 10% rate as opposed to capital gains that could be as high as 23.8% for your client.
In both of these cases your client doesn’t have to wait until their student is in college. If there are significant unrealized capital gains your client may want to start the process while their student is in high school or even middle school. There is a limited amount each year and your client can slowly chip away and pay 0% capital gains for several years leading up to college.