*Editor’s Note- This blog was originally posted October 16, 2018 but has been updated as of December 12, 2019 for accuracy and comprehensiveness.

Often times parents will invest on behalf of their children to give them a financial head start. This triggers something called the “kiddie tax”. It taxes all but a small portion of a child’s unearned income — such as dividends, capital gains and interest — at his or her parents’ marginal tax rate. The Tax Cuts and Jobs Act (TCJA) has revamped this tax—learn more about what has changed.

The kiddie tax

The kiddie tax was designed to prevent parents from lowering the family’s tax bill by transferring income-producing assets to children in lower tax brackets. Prior to tax reform, the kiddie tax required a child’s unearned income (dividends, interest and capital gains) over $2,100 to be taxed at the parents’ tax rate instead of the child’s generally lower rate.

Generally, the kiddie tax applies to all children age 18 or younger, as well as to full-time students who are between 19 to 23 years old, who are claimed as dependents by their parents.

Changes under the TCJA

The TCJA retains the general idea of the kiddie tax but now, instead of being taxed at the parent’s marginal tax rate, the child’s unearned income will be taxed at the federal income tax rates applicable to trusts and estates.

As you can see in the chart, for 2019, trusts and estates are taxed at the highest marginal rate of 37% once taxable income exceeds $12,750. On the other hand, for a married couple filing jointly, the highest rate doesn’t take effect until their taxable income tops $612,350.

By the same token, the 15% long-term capital gains rate kicks in at $78,751 for joint filers but at only $2,650 for trusts and estates. Additionally the 20% rate takes effect at $488,851 and $12,950, respectively.

So, in many cases, shifting income to children will not be worthwhile. Children’s unearned income will be taxed at higher rates than their parents’ income. Hence, attempting to shift income to children subject to the kiddie tax will not save tax and could even increase the family’s overall tax liability.

New Planning Opportunities

Be sure to consider the kiddie tax before transferring income producing or highly appreciated assets to a child or grandchild who’s a minor or college student. You don’t want to inadvertently increase your family’s tax liability.

Often, the best way to minimize the kiddie tax is for your children to avoid investments that generate taxable income. It may make sense to invest in tax exempt bonds or funds that pay qualified or capital gain dividends. You can shield your child’s savings from your higher tax rates by using vehicles, such as Roth IRAs and Section 529 college savings plans, that offer tax-free earnings and withdrawals. An added benefit of Sec. 529 plans is that they’re generally treated as the parents’ asset for financial aid purposes.

If you have adult children (in a lower tax bracket) who’re no longer subject to the kiddie tax, consider transferring assets to them to save tax.

Many parents and grandparents make financial gifts to their children at the end of the year but you might reconsider your approach this year! Now is a good time to start the process of passing along your wealth, while taking into account important TCJA changes.

Need help with your tax planning? Contact any member of our Tax Services Team.

The TCJA…So Many Changes, So Many Questions…we can help you navigate this huge tax overhaul! Visit our Tax Reform Center for everything you and your business need to know, now.