Liquidate Appreciated Securities Tax-Free For College Funding By Avoiding The Kiddie Tax by Michael Kitces
The “kiddie tax” rules were created to limit the ability of families to save on taxes by simply shifting income – especially investment income – from higher-income family members (like parents) to lower-income family members (such as children) to take advantage of their lower tax brackets.
Yet while the kiddie tax rules are unavoidable for young children, it is often possible to avoid their reach for college students, who are not subject to the kiddie tax if they also generate enough earned income from wages and self-employment, or choose to attend school part time.
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Of course, working to generate income should hopefully be its own reward, but by avoiding the kiddie tax, parents can subsequently gift (or liquidate previously gifted) appreciated investments, and allow the child to take advantage of what is currently a 0% federal tax rate on long-term capital gains for those in the bottom two tax brackets. Repeated over the span of several years, this can add up to a material amount of tax savings for the family, especially when coupled with other tax savings opportunities of a financially-self-supported child, including a larger standard deduction, personal exemptions and the American Opportunity Tax Credit!
Understanding the kiddie tax rules
The kiddie tax is actually a set of rules that requires a child’s “investment income” (technically, any income of the child that is not earned income from wages or self-employment) to be taxed at their parents’ top marginal tax rates. The rules were put in place as a part of the Tax Reform Act of 1986 to limit a family’s ability to reduce its taxes on investment income by simply “spreading the wealth” across the family and especially to the children, who without much of any other income would be taxed at the lowest interest, dividend and capital gains rates.
Technically, a child with some unearned income is eligible for a limited standard deduction of $1,050 (in 2015), and the next $1,050 actually is taxed at the child’s tax rates. However, any additional investment income beyond the first $2,100 is taxed at the parents’ tax rates (or alternatively, with less than $10,000 of interest, dividends, and capital gains, the child can actually opt to have the income reported on the parents’ tax return, which produces the same tax result but avoids the cost and hassle of filing a tax return for the child). To the extent the child actually has earned income from self-employment, the income is always taxed at the child’s rates.
In order for the kiddie tax to apply, the child must either:
- Be under age 18 (as of the end of the year)
- Be age 18 with earned income that is less than one-half of the child’s own support (i.e., if the child has earned income more than one-half of their own support needs, the kiddie tax will not apply)
- Be a full-time student under age 24 whose earned income did not exceed one-half of his/her own support
For the purpose of these rules, the determination of what constitutes “support” is the same as the “support test” in determining whether a child is a dependent. Thus, “support” includes the cost of food, clothing, shelter, education, medical and dental care, recreation and transportation. Notably, while “education” costs are included – which means tuition as well as other education-related costs – the cost is generally reduced by any payments that were covered by scholarships.
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