Avoid the Kiddie Tax
By
Roy Lewis
December 15, 2000
Oh, how I long for the "good old days."
In tax parlance, the "good old days" were when we could easily transfer money and/or assets to our minor children, and then have the kids sell the assets and/or invest the funds and pay taxes at their lower tax rates. It was a beautiful thing, especially for parents in very high marginal brackets. Imagine taking a $10,000 gain that would have been taxed at your marginal rate of, say, 36% and having it taxed at your kid's rate of 10% or less. Sign a few documents, and the family saves $2,600!
But, Uncle Sammy didn't think this tax move was all that pretty, which is why the tax incentives to shift income from a parent to a minor child were nearly eliminated in 1986 when Congress enacted a "kiddie tax." Generally, for a child under age 14 at the end of the year, the kiddie tax provides that the child's unearned income (including capital gains) is taxed at his parents' highest marginal rate.
Sure, the kids can receive a floor amount of unearned income that will escape the kiddie tax provisions ($700 in unearned income for year 2000, annually adjusted for inflation). But, it doesn't take much to generate more than $700 in unearned income... especially if the child is invested in a "hot" stock, or receives an unanticipated year-end mutual fund distribution.
Planning opportunities
The demise of income shifting to your children has been greatly exaggerated. While it takes a bit more planning, there are still methods that you can use to minimize the kiddie tax and keep your income shifting alive and well. Here are some of the most popular:
Wait until age 14. Since the kiddie tax rules no longer apply in the year that the child turns 14, simply wait until that year to make gifts of assets or property that would generate significant amounts of investment or unearned income.
What about the first 14 years of the child's life? Well, if you can't wait to make significant transfers, the tax will be computed and paid at your higher rate. At least you can avoid the complexities of computing the kiddie tax. Don't despair completely -- you can still make smaller transfers during those years and manage the assets for the child to minimize the unearned income.
Invest for growth and hold.Remember that if there are no realized gains, there is no tax... kiddie or otherwise. So, consider investing the child's assets in growth stocks that pay little or no dividends. Invest in good, strong, solid companies that will grow over time. Then, when the youngster turns 14, you can plan sales, gains, diversification, or even use of the funds when the gains will be taxed at the child's rate. This is actually a very Foolish way to go... investing for growth in solid companies.
Insurance and annuities. While I'm no big fan of whole life or deferred annuities, they can have their place in an overall financial plan. This could be one of those cases. You might consider transferring a whole life insurance policy or deferred annuity to the child. This can work because the buildup of the whole life policy or deferred annuity is not taxed until the payment is made to the child. Proper planning will allow for the payout after the child turns age 14, thereby escaping the kiddie tax.
An added benefit is that this maneuver can provide the child some added financial protection if the insurance policy is on the life of a parent.
This gambit can also cause some other unintended estate tax problems. So, you might want the help of a qualified estate-planning pro to review all of the relevant issues prior to making such transfers.
Savings bonds. Consider (but only for a nanosecond) investing in tax-deferred investments such as United States savings bonds (Series EE) that will not mature until after the child is age 14. Again, because of the nature of savings bonds, no tax will be due until after the bond is redeemed.
This is really a last-resort type of dodge. The earnings on savings bonds aren't really what you want to grow the kid's account. Heck, the interest rate hardly keeps up with inflation. But, if the child has a fairly large existing portfolio of growth stocks, and you are looking for some diversification, you can make this type of investment fit the bill.
Divorce. No, I don't mean file for divorce. Rather, know that if the child's parents are divorced, legally separated, or treated as not married, only the taxable income of the custodial parent is taken into account to determine the child's kiddie tax liability. If an under-age-14 child will have significant unearned income, the most favorable tax results will be achieved if the parent with a lower marginal tax rate has custody of the child.
Note, however, if the custodial parent files a joint return with a spouse who is not a parent of the child, the total taxable income shown on the joint return is used to determine the parent's taxable income for purposes of the kiddie tax.
Hire 'em. Remember that the kiddie tax rules only apply to unearned income. Earned income is exempt from the kiddie tax rules. So, if you have a business, consider hiring the little tykes. Think the kids are too young? Even a 5- or 6-year-old can be taught to sweep floors, take out the trash, seal envelopes, or run a milling machine (just kidding about that last one). You can pay them generous, but defensible, hourly rates. Not only will the child receive earned income rather than unearned income, the business can claim a deduction for reasonable compensation paid to the child.
These are just a few ideas that you can use to plan around the kiddie tax rules, and there are certainly others. There are enough options available to keep the kiddie tax from completely killing your hope of transferring wealth to the kids at a lower tax rate. It simply takes some additional planning.
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