Parents: Tax Reform Just Opened Up a New Planning Opportunity

The tax reform laws that just went into effect at the beginning of the year included some massive changes to the federal tax system. New tax rates, new levels at which each rate bracket begins and ends, and higher standard deductions are just a few of the high-profile changes that could result in large savings for some taxpayers.

For families with children, one key change to tax reform went largely unnoticed by the general public. The move made amendments to what has colloquially been known as the "kiddie tax" -- a provision that puts limits on parents being able to escape taxation by putting assets in their children's names. With the new provision in place, there are new opportunities some families will be able to use to their advantage. Below, we'll go through the kiddie tax and what changed to make it possible to plan around its provisions.

Image source: Getty Images.

What's the kiddie tax?

The kiddie tax applies to children under age 19 or who are full-time students under age 24, if they have unearned income from interest, dividends, or other investment income. Under old tax law, the kiddie tax was relatively simple. The first $1,050 of unearned income was free of tax, and the next $1,050 was taxed at the child's rate. Above $2,100, the child paid whatever amount of tax on that unearned income that the parents would have had to pay had their included the child's income on the parental tax return.

In practice, the kiddie tax is extremely complicated to calculate. A long worksheet requires you to collect numbers from both the child's tax return and the parental tax return and then perform a long list of calculations to come up with the right amount of kiddie tax liability. In order to simplify matters, a rule applied that allowed some parents to elect just to put the child's income directly onto the parental tax return.

The net result was that it didn't make sense for parents to shift assets to their children if it would result in more than $2,100 of investment income. If it did, then the kiddie tax would simply force them to pay the same tax that they would have if they'd kept the assets themselves.

What changed with the kiddie tax and reform?

Tax reform fundamentally changed the way the kiddie tax works. The way the first $2,100 in unearned income gets handled remains the same: no tax on the first $1,050, and the child's rate on the next $1,050.

After that, though, the parental tax rate plays no role in determining additional tax. Instead, the brackets for trusts and estates apply. For 2018, that results in the following:

Data source: IRS.

That's a huge boon for high-income taxpayers. Under the old law, the first dollar above the $2,100 initial limit could have been taxed at the maximum 37% rate. Now, parents will have a big incentive to move enough assets to generate a total of $11,250 in income attributable to their kids, because the income will get taxed at relatively favorable rates of 10% to 24%. For those whose parents are in the top tax bracket, this change could save as much as $1,547 by making maximum use of the changed rates.

The way that favorable rates for qualified dividends and long-term capital gains interact with the new provisions also offer some opportunities for savings. Under the old law, the preferred rates on qualified dividends and long-term capital gains were determined by parental income, with parents in the lowest two tax brackets paying 0%, and all others paying 15% except for top-bracket taxpayers, who paid 20%. Now, the trust and estate brackets determine that taxation. The brackets applying to capital gains aren't exactly aligned to the regular tax brackets above, but the upshot is that up to $2,600 in qualified dividends or capital gains above the first $2,100 in income could get the preferred 0% rate, with 15% rates applying on further gains up to $12,700, at which point the 20% bracket kicks in. Whether that's a savings or an added cost depends on the amount of dividends and gains and the parents' tax bracket.

Some things to watch out for

There are some trade-offs involved in using this kiddie tax strategy. The most obvious one is that in order to have unearned income reportable on a child's tax return, the child has to have income-generating assets. That can be problematic because most parents don't want their children to have direct control over extensive financial assets. It can also raise some difficulties with financial aid, because investment assets titled in the name of a child are treated as the child's financial resources, which can precipitously reduce aid eligibility. For many wealthier families, though, financial aid wouldn't generally be available anyway, and they can use various estate planning techniques to add some protections for kids trying to tap their funds in ways their parents wouldn't approve.

Tax reform had a number of little-noticed provisions, some of which predominantly help a select group of taxpayers. Although the new kiddie tax provisions could potentially save middle-class taxpayers some money, the biggest benefits will go to those with the financial resources to provide their children with enough investment income to max out its low tax rates.

Editor's note: A previous version of this article misstated the tax rate for the second tax bracket under the kiddie tax provisions. The author and the Fool regret the error.