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How to Work Around Intricate 'Kiddie Tax' Rules

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Nov 4th 2014
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The Tax Reform Act of 1986 introduced the complicated "kiddie tax" rules. They drastically restricted the ability of higher-bracket parents and grandparents to shift investment income from themselves to their lower-bracket children and grandchildren by gifts of cash, stocks, mutual fund shares, real estate, money and other income-generating assets. It's possible to work around them, but you have to know all the ins and outs.

How did Congress clamp down on income-shifting maneuvers? Our lawmakers targeted children under the age of 14 who received investment income. The 1986 act imposed the parent's top rate on such income. But children who had attained the age of 14 were unscathed by that year's version of tax reform. The legislation retained the old rules for those children. It said they should continue to be taxed at the children's rate.

When did the 1986 measure apply parental rates to children's income? When a child under the age of 14 received "unearned" income. This meant investment income from interest, dividends, capital gains from sales of assets or distributions from mutual funds, rents, and other kinds of unearned income.

The act authorized some relief from kiddie taxes. They kicked in only when a child's investment income exceeded a specified threshold that subsequently was adjusted annually, as explained below. No relief, though, for earnings that were generated by money or other assets received by the child from persons other than parents—grandparents or aunts, for example.

The rules introduced by the 1986 act have been amended several times. But previous versions and the one on the books for 2014 are consistent. They generally tax the excess income at the parent's top rate, which can be much higher than the child's. For instance, they tax interest income at the rates for salaries, pensions, profits from self-employed ventures, and other kinds of ordinary income.

For 2014, those rates go as high as 39.6 percent, versus a top rate of 20 percent for dividends from stocks and stock funds and for long-term capital gains from sales of individual stocks, shares of mutual funds and most other assets. Note that 2014's maximum rate is more than 39.6 percent for individuals subject to: the Medicare surtaxes on investment income or earnings; or phase-outs for dependency exemptions and certain itemized deductions because their adjusted gross incomes surpass specified amounts.

More complications. The specified amount that triggers kiddie taxes changes each year. That amount is indexed, same as the income tax brackets, standard deduction amounts, and dependency exemption amounts.

For 2014, the inflation-adjusted threshold of $2,000 breaks down as follows: The first $1,000 of income is relieved of taxes, courtesy of the child's $1,000 standard deduction for unearned income. Income between $1,000 and $2,000 gets taxed at the child's own rate, which can be as low as 10 percent for interest and short-term capital gains and zero percent for dividends and long-term capital gains. When a child's income comes solely from dividends and long-term gains and aggregates less than $2,000, the tax is zero. When the income comes solely from interest, the tax goes no higher than $100—$1,000 times 10 percent.

Age limits. A revenue-hungry Congress keeps extending the cut-off age for kiddie taxes. The 1986 act terminated the kiddie tax in the year a child attained the age of 14. Then a law change ended it when a child became 18. Under the current rules, there are two age limitations.

Under the first limit, it ends when a child reaches 19. The second limit applies only to a fulltime student under the age of 24 whose earned income doesn't represent at least one-half of his or her support. Scholarships don't count in determining total support.

Once beyond the age limits, the child's income from capital gains and dividends could be well above $2,000, yet continue to be taxed at zero percent. Using 2014 as a marker, not until taxable income surpasses $36,900 does a single person move beyond the 15 percent bracket and ascend to the 25 percent bracket.

Strategies. There remain ways for parents to sidestep kiddie taxes and divert some of a child's investment income into a lower bracket. Their strategy should be to give assets that produce no taxable income or postpone income until kiddie taxes no longer kick in and the earnings are taxed at the child's rate. Appropriate gifts include: growth stocks; mutual funds that currently pay only modest dividends but are expected to appreciate substantially; and tax-exempt municipal bonds and bond funds.

About the author:

Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator) and an attorney. More on this topic is available from "Julian Block's Year Round Tax Strategies", available at julianblocktaxexpert.com.

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