Transferring assets to your children can be a wonderful introduction to investing for them, and a simple tax-saving strategy for you. In general, children are in a lower tax bracket than their parents. It seems that a smart tax-planning move would be to “gift” your appreciating assets directly to your children, to avoid paying tax at your higher rate.
However, in order to avoid abuse of this situation, the tax law states that certain unearned income of dependent children is taxed as if it is the income of the parents. This provision is often called the “kiddie tax.” Knowing the limits and guidelines of the “kiddie tax” can help you take advantage of tax-planning opportunities involving gifts to your children.
What Is the “Kiddie Tax”?
The “kiddie tax” is the additional tax your child must pay above their own tax rate on unearned income over a certain threshold. A dependent child’s unearned income over $2,100 is subject to tax at your tax rate — which is likely higher than their individual rate.
Unearned income generally refers to passive income, such as interest, dividends, capital gains or income from a passive partnership interest. Earned income, like income from working a summer job or other employment, is not subject to taxation at the parent’s rate at any amount.
How Does This Impact My Tax Planning?
Understanding the “kiddie tax” rules can help you determine how much of your appreciated investments should be transferred to your child for potential tax savings, while avoiding subsequent taxation at your higher tax rate.
Here’s an Example
Assume that 5 years ago, you purchased 10 shares of a stock for $50 a share ($500). Today, that stock is worth $250 a share ($2,500). If you sell those shares today, you will pay tax on the $2,000 of gain you’ve realized at your tax rate.
Now assume that instead of selling those shares, you gifted them to your child. If your child sold those shares today, they would still realize the same $2,000 gain on the sale, but the tax due would be calculated at their generally lower tax rate. Depending on your tax situation, you may be able to save up to $750 by transferring your assets to your child. If you transfer similar assets to more than one child, your tax savings could increase. (Be sure to limit your total gifts for the year to $14,000 per donee to avoid gift tax implications).
However, let’s assume that the shares gifted to your child had appreciated to $300 each ($3,000). Upon sale, the gain increases to $2,500. Since the “kiddie tax” threshold is $2,100, the first $2,100 of that gain would be taxed at your child’s rate and the remaining $400 would be taxed at your rate.
Gifting money and assets to your children is a personal matter, and there are many factors to consider. Be sure to consider the “kiddie tax” in your planning.