While most individuals are taxed on their earned income at their own individual tax rates, unearned income is a very different beast—especially when it comes to a child’s unearned income. The Tax Cuts and Jobs Act made some significant changes in the way a child’s income is taxed.
Taxpayers often receive unearned income in the form of dividends or interest on investments, royalties, rents, and inheritances. In general, the IRS does not want parents to shift income-producing assets to a child under the age of 19 (or a full-time student under the age of 24), who is in a lower tax bracket. Enter the Kiddie Tax, where until Dec. 31, 2017, part of a child’s investment income was subject to tax at the parents’ top marginal income tax rate.
With the new tax laws, the first $2,100 is income tax-free because of the standard deduction
When a child, who can be claimed as a dependent by another taxpayer, only has unearned income, his or her standard deduction is $1,050. However, when a child also has earned income, the blended standard deduction becomes the greater of $1,050 or earned income plus $350, not to exceed the full standard deduction for an individual.
With the Tax Cuts and Jobs Act, a child’s unearned income in excess of $2,100 will be taxed at the rates that apply to trusts and estates—the parents’ top marginal tax rate won’t matter anymore. The first $2,550 is taxed at 10 percent, then investment earnings between $2,550 and $9,150 are taxed at 24 percent. The third bracket is from $9,150 to $12,500 and has a marginal rate of 35 percent. Anything above $12,500 will be taxed at 37 percent.
Now to put this in perspective, let’s say you have a custodial account for your child, holding McDonald’s stock, which pays about a 2.27 percent dividend yield. For your child’s unearned income to be taxed at 37%, the account would need to be more than $550,000! At McDonald’s current price, that’s well over 3,000 shares. For wealthy families, this change isn’t going to have a big impact. Chances are if your dependent child has more than half a million in invested assets it’s quite possible you too are in the 35 percent or 37 percent tax brackets, and you’re accustomed to having your child’s income taxed at your top rate.
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The new Kiddie Tax rates can affect middle-income families. Let’s say you and your spouse have taxable income of $135,000. Your child’s grandfather passes away and your child inherits a stock portfolio that generates around $5,500 in dividends a year. Under the 2017 rules, the first $1,050 of this was income tax-free. The next $1,050 was taxed at the child’s tax rate of 10 percent. That left $3,400 that was taxed at the parents’ top marginal rate of 25% for a total tax of $955 (($1,050 x 10%) + ($3,400 x 25%)).
With the new tax laws, the first $2,100 is income tax free because of the standard deduction. The next $2,550 will be taxed at 10 percent and the remaining $850 will be taxed at 24 percent for a total tax of $681 (($2,550 x 10%) + ($1,900 x 24%)).
In most cases, the Tax Cuts and Jobs Act’s Kiddie Tax rules will result in lower taxes; however, lower income parents who have children with substantial unearned income could see their child paying a higher tax rate because of the compressed trust and estate brackets.
William G. Lako, Jr., CFP®, is a principal at Henssler Financial, a financial advisory and wealth management firm that has been delivering comprehensive financial solutions to its individual, corporate, and institutional clients for 30 years. Mr. Lako is a Certified Financial Planner™ professional.