At one time, long, long ago, a common tax strategy was to shift investment income from a parent to their child (children) to take advantage of the child’s (children) lower tax bracket/rate. This planning strategy was eliminated with the introduction of the kiddie tax. Like every other stopgap measure, CPAs and tax attorneys, around the country, found loopholes and strategies to get around the original kiddie tax rules. In response, Congress continues to tweak the kiddie tax rules. Here are some of the current rules/tax planning strategies regarding the kiddie tax.
The kiddie tax applies to investment income (dividends, interest and capital gains) of a child who is:
1. Under age 18 at the end of the year or;
2. Age 18, unless the child’s earned income is more than 50% of his or her support or;
3. Age 19-23 and a full-time student
When the kiddie tax applies, the child’s investment income is taxed at the parent’s tax rate, rather than the child’s, to the extent that such income exceeds $1,900 per year (in 2009). The parent has the option to report the kiddie tax on their individual income tax return or on the return of their child (children).
Tax Planning Strategies:
1. Invest the child’s assets in property that generates tax exempt income. For example, municipal bonds;
2. Invest the child’s assets in investments that defer tax, such as individual stocks, exchange traded funds, real estate investment trusts, variable annuities, fixed annuities, permanent life insurance, commodities etc.
3. Invest a portion of the child’s assets in U.S. Savings Bonds and elect to report the interest each year. This strategy works as long as the interest on the U.S. Savings Bonds do not exceed the $1,900 threshold;
4. If the child has earned income, invest the assets that are generating taxable investment income in Roth IRAs. Roth IRA qualified distributions are never subject to income tax.