Parents do whatever they can to meet their children's financial needs. With rising costs of college and the threat of crippling student loan debt, many parents focus on trying to save to help their kids get the education they want. Setting up an investment account in a child's name is one way to do that. But if you're not careful, you can end up getting an unexpected tax bill as a result of your efforts -- despite your best intentions.
At the center of the tax debate involving parents and children is what's known as the kiddie tax. Originally intended to prevent parents from using their kids to get unfair tax advantages, the kiddie tax went through major changes in late 2017 as part of the broader tax reform package at the time. More recently, though, lawmakers decided to shift some of those provisions back, making parents once again get up to speed on which laws apply.
Kids as tax shelters
Before the kiddie tax was in effect, taxpayers could set up their financial affairs to benefit from differences in tax rates between parents and children. By creating investment portfolios in the name of a child, the income from those investments could get taxed at the child's lower tax rate. Given that most children have little or no income of their own, some investment income could actually avoid tax entirely using this strategy, and even those children who did have some income would nevertheless typically be in far lower tax brackets than working parents with considerable salaries.
The kiddie tax aimed to stop this strategy by forcing children to pay their parents' tax rate on income above certain levels. Money that children earned through legitimate employment was generally protected, but investment income above the thresholds typically incurred the same amount of tax as it would have if the parents had kept the investments in their own names.
A brief change
Tax reform changed the rules, though, and for two years, a different system applied. Rather than using parents' tax rates, the rules forced taxpayers to use the rates for trusts and estates. Those rates run from 10% to 37%, just like tax brackets for individuals and couples, but the income levels are greatly compressed. For instance, the top 37% bracket kicked in at just $12,750 for the 2019 tax year.
The change had two consequences. For families with high enough income to be in the top tax bracket, the new rule let taxpayers take advantage of lower rates on trusts and estates, albeit for a relatively small amount of income. But more troublingly, because scholarship income was treated as being subject to the kiddie tax, the compressed brackets meant that even low-income families got charged high tax rates because of the provision.
The fix Congress made
To remedy that second situation, lawmakers passed legislation that essentially returned the kiddie tax rules back to what they were prior to tax reform. The changes, which are included as part of the SECURE Act, are effective beginning in the 2020 tax year.
However, taxpayers can also elect to have the old rules applied retroactively to their 2018 and 2019 tax returns. That'll be the best of both worlds, allowing those who benefited from the new rules to keep those benefits while solving problems for those who got hurt by the provisions.
For those who used tax reform's kiddie tax changes to their advantage in 2018 and 2019, the latest move from lawmakers might be a disappointment. But those who found themselves unexpectedly paying huge taxes as a result of the change will be pleased that Washington did something to make things right from their perspective.