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Tax on Investment Income of Children May Increase Under New Kiddie Rules

Only one change was made in the “kiddie tax” under the Tax Cuts and Jobs Act, but it could be significant. Children will be no longer be taxed on unearned income at the parents’ tax rate (the “kiddie tax” rule). Instead, the estate and trust income tax rates will apply.

This may sound simple and not so bad; however, it could result in a higher tax on children’s income for some parents.

Like many topics this year, taxpayers should get tax advice that is tailored to their unique situation before making gifts to children or grandchildren.

Kiddie Tax Basics

The kiddie tax is designed to impose the parents’ tax rate on the net unearned income of children. The purpose is to prevent parents from income-shifting to family members who are in a lower tax bracket.

Unearned income includes taxable interest, ordinary dividends, capital gains, rents, royalties, etc. It also includes taxable social security benefits, pension and annuity income, taxable scholarship and fellowship grants not reported on Form W-2, unemployment compensation, alimony and income received as the beneficiary of a trust.

The kiddie tax applies in the following circumstances:

  1. The child is under age 19 by the close of the tax year or is a full-time student age 19 to 23;
  2. The child’s unearned income exceeds an inflation-adjusted amount (set at $2,100 for 2018); and
  3. The child does not file a joint return.

For a child age 18, or a child age 19 to 23 who is a full-time student, the kiddie tax rules apply only if the child’s earned income does not exceed one-half of the child’s support.

The kiddie tax is figured on Form 8615.pdfTax for Certain Children Who Have Unearned Income. This form is attached to the child’s tax return. A child required to file Form 8615 also may be subject to the 3.8% Net Investment Income Tax (NIIT) and the alternative minimum tax (AMT).

 If the child’s only income is interest and dividend income, including capital gain distributions, and totals less than $10,500, the parents may be able to elect to include that income on the parents’ return rather than file a return for the child.

Why the Trust Rates Could be Higher

Beginning in 2018, children will pay tax on their unearned income using the same tax tables as trusts (shown below) instead of at their parents’ regular income tax rates (also shown below). This change simplifies computation of the tax but could result in the children paying higher taxes than under the old rules.

Income Tax Rates for Estates and Trusts
Estates and Trusts Income Tax Rates
$0-$2,550 10%
$2,551-$9,150 24%
$9,151-$12,500 35%
Over $12,500 37%

 

Income Levels and Filing Status
Tax Rate Single Married-Joint
10% $0-$9,525 $0-$19,050
12% $9,526-$38,700 $19,051-$77,400
22% $38,701-$82,500 $77,401-$165,000
24% $82,501-$157,500 $165,001-$315,000
32% $157,501-$200,000 $315,001-$400,000
35% $200,001-$500,000 $400,001-$600,000
38.5% $500,000+ $600,000+

 

Why is the tax higher? Because the top 37% rate kicks in at $12,500 for estates and trusts and not until $600,000 for married couples.

For capital gains, the 20% trust capital gains rate kicks in when taxable income reaches $12,700. For married couples, the 20% capital gains rate does not apply until taxable income exceeds $479,000.

In short, higher tax rates are imposed on trusts at much lower income levels than for individuals.

Whether this change results in an actual increase in tax on children’s unearned income will depend on how much income is subject to the kiddie tax and in which tax bracket the parents are. The child would only pay higher taxes if the parents are in a lower bracket, which is not likely given the usual taxpayers who gift unearned income to their children.

Still, because of the potential for higher taxes, parents and grandparents should get tax advice before making gifts to children and grandchildren which could result in a substantial amount of unearned income for the child.

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