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There was a time not so long ago when, by way of gifting funds to children, parents could shift the tax cost on investing funds to their children. This was a pretty genius idea given that children often don’t have much (if any) taxable income, making tax on investment income even lower or non-existent. Sadly, it doesn’t quite work that way these days. The IRS got wise to this strategy in 1986 and instituted the Tax on a Child’s Investment and Other Unearned Income Tax, affectionately referred to as the “kiddie tax.”
The kiddie tax rules were designed to prevent parents from shifting unearned income such as interest, dividends, capital gains and/or real estate income to a child to take advantage of lower tax rates.
In 2017, up to $2,100 of unearned income received by a child enjoys the lower (or potentially zero) tax rate of the child while income above this amount flows right over to the parents’ return to be taxed at their marginal rate. The tax is applied to funds held by children under 19 years old or 23 years if a full-time student does not provide more than half of their own support. Most commonly, investments held in UGMA or UTMA accounts (depending on state, opened under either the Uniform Gift to Minors Act or Uniform Transfer to Minors Act, respectively) are subject to this tax.
To put the kiddie tax into perspective, the dividend rate on the S&P 500 is currently around 2% (as of June 2016). Assuming no other investments or earnings, a child with an UGMA or UTMA account balance in excess of $105,000 will be subject to the kiddie tax ($105,000 x 2% = $2,100).
Related: What to Do With Funds Saved to 529 College Savings Plans
So, depending on current income rates on investments and account balances, the tax may not come into play. Still, since no one likes surprises – particularly tax surprises – it’s important to keep in mind.
If your child has an UGMA or UTMA account, be sure to give your tax preparer Form 1099, provided by the investment custodian each year, so that he or she can prepare a return for your child if necessary (or add it to yours).