New Kiddie Tax Rules Could Result in Big Changes
The 2017 Tax Cuts and Jobs Act (2017 TCJA), modified the Kiddie Tax to effectively apply the estates' and trusts' ordinary and capital gains rates to the net unearned income of a child. The tax rates for trusts and estate increase much more quickly than those applying to individuals.
Previously, the Kiddie Tax applied to the unearned income of a child that exceeded an inflation-adjusted amount ($2,100 in 2017). The Kiddie Tax applied to children under the age of 19 or dependent children who were full-time students ages 19-24 and was imposed using the parents’ marginal tax rate, if that tax was higher than what the child would have otherwise paid. Unearned income generally included all income except wages, salaries, self-employed earnings, and other amounts received as compensation for personal services rendered. Examples of unearned income include capital gains, dividends, interest, and inherited IRA distributions). A child with no earned income would not be taxed on the first $1,050 of unearned income (which was the standard deduction for a child claimed as a dependent on another return); the next $1,050 would be taxed at the child’s rate—then any unearned income above $2,100 was taxed at the parents’ marginal tax rate.The Kiddie Tax was put in place to counteract a variety of family income-shifting techniques that took advantage of the lower tax rates of the taxpayer’s children by, in effect, taxing the family unit as a whole.
Under the old rules, calculating the tax on the child’s excess unearned income wasn’t as simple as just multiplying the income by the parents’ marginal rate. Instead, the parents’ tax was computed with and without the child’s excess unearned income, with the difference being the tax on such amount. In some situations, this approach caused the parents’ tax computation to cross over into a higher tax bracket, resulting in a higher marginal rate on some or all of the child’s excess unearned income.
Beginning in 2018, a married couple pays the top 37% marginal income tax rate when their taxable income exceeds $600,000. However, for estates and trusts, the top 37% rate kicks in when income exceeds $12,500, which is a much lower threshold.
Estates and Trusts Income Tax Rates
Taxable Years Beginning in 2018
If Taxable Income Is:
The Tax Is:
Not over $2,550
10% of taxable income
Over $2,550 but not over $9,150
$255 plus 24% of the excess over $2,550
Over $9,150 but not over $12,500
$1,839 plus 35% of the excess over $9,150
$3,011.50 plus 37% of the excess over $12,500
Under the 2017 TCJA changes, the rules below apply in lieu of the above described Kiddie Tax computations.
- The maximum amount of taxable income taxed at rates below 24% can't exceed the child's earned taxable income + (for 2018) $2,550 (the minimum taxable income for the 24% bracket in the Estate and Trust Income Tax Table).
- The maximum amount of taxable income taxed at rates below 35% can't exceed the child's earned taxable income + (for 2018) $9,150 (the minimum taxable about for the 35% bracket in the Estate and Trust Income Tax Table).
- The maximum taxable income taxed at a rate below 37% can't exceed the child's earned taxable income + (for 2018) $12,500 (the minimum taxable amount for the 37% bracket in the Estate and Trust Income Tax Table.
For purposes of applying the capital gains tax rates:
- The maximum amount of capital gains taxed at a zero rate can't exceed the child's earned taxable income + (for 2018) $2,600; and
- The maximum amount of capital gains taxed at a 15% rate can't exceed the child's earned taxable income + (for 2018) $12,700.
Overall, the new rules should simplify the tax calculation for many families. Now, the same rates apply to all children, instead of having varying rates based upon the parents’ income. Also, the child's tax will no longer be affected by the unearned income of any siblings.
The TCJA doesn't change the definition of a child subject to the Kiddie Tax for purposes of the above-described modified Kiddie Tax rules in effect for 2018–2025. Unless Congress changes the applicable law, these changes don't apply for tax years beginning after Dec. 31, 2025.
What Do These Changes Mean for You?
At first blush, it may appear that because of the compressed tax brackets that top out at $12,500 that you will have bigger tax bills than in the past. However, that is not necessarily the case. For parents in higher tax brackets, the change may actually benefit the kids. Unearned income (above $2,100) that may have been previously taxed at 39.6% or could potentially only be taxed at 10% for the first $2,550, and 24% if between $2,550 and $9,150, or if the unearned income qualifies for preferential tax rates 0% or 15% instead of the parent’s 23.8% rate. That’s a huge difference! This change could also end up costing the kids more. However, this situation may be more unlikely. A child would have to have substantial unearned income with parents in a lower tax bracket than the child.
Parents should always be aware of the impact of realizing large gains in children’s accounts. Selling assets in a child’s portfolio to help finance college costs could mean the Kiddie Tax applies. Consider starting the sell-down process sooner to help manage gains and reduce the Kiddie Tax. Be sure to position yourself financially to take advantage of the 0% or 10% tax rate. Or consider gifting appreciated securities to students first and then having them sell the securities and utilize the capacity of their 0% and 10% rate as opposed to the parents’ higher capital gains rate (which could be as high as 23.8%). Strategizing now could result in potential tax savings.
About Tina A. Myers, CFP®, CPA/PFS, MTax, AEP®
As a senior financial planner with Key Private Bank, Tina offers her clients sophisticated financial planning advice and a comprehensive set of strategies to grow and preserve their wealth. She collaborates with her team’s Relationship and Portfolio Managers, coordinates strategies with attorneys and accountants and follows up on a regular basis to ensure the plan is performing optimally. Tina received the 2016 Exceptional Service Award from the Cleveland Estate Planning Council and 2016 Circle of Excellence Award by Key Private Bank.