In last week’s blog post, I covered the various options for holding assets meant to benefit your child. This week, we’ll take a look at the tax planning issues surrounding assets held for or by your children, as well as how the assets impact eligibility for financial aid.
When it comes to taxes, one of the IRS principal concerns in this situation is to avoid allowing assets to be shifted to children with the primary aim of reducing taxes. Their primary tool to discourage this is known as the kiddie tax. The kiddie tax was first implemented with the tax reform bill of 1986, and the law says that if passive income for a child is above a certain level, under specific conditions, that income will be taxed at the parents’ tax rate. The specific rules as outlined on the IRS website are as follows:
- The child’s unearned income was more than $2,100
- The child meets one of the following age requirements:
- The child was under age 18 at the end of the tax year
- The child was age 18 but less than 19 at the end of the tax year and the child’s earned income didn’t exceed one-half of the child’s own support for the year (excluding scholarships if the child was a full-time student), or
- The child was a full-time student who was at least 19 and under age 24 at the end of the tax year and the child’s earned income didn’t exceed one-half of the child’s own support for the year (excluding scholarships)
- At least one of the child’s parents was alive at the end of the tax year
- The child is required to file a tax return for the tax year, and
- The child doesn’t file a joint return for the tax year
The aim of the rules above is to make sure you don’t shift income to a dependent child (up to the age of 24) in order to reduce the tax on that income. Note that the kiddie tax is meant to tax passive income at the parents’ tax rate, and not a child’s earned income. In other words, if you have a teen who is working and being paid for her work, that income will be taxed at her tax rate as it is active income and not income generated from investments.
It is worth noting, for tax planning purposes, that 529 accounts aren’t subject to the kiddie tax because growth and income in the accounts aren’t taxable. This is one of the primary tax advantages of 529 accounts, particularly those with more significant balances. Thus, a 529 is the most tax-efficient conventional vehicle you can use if your goal is to fund your child’s education.
Another tax planning consideration that can come into play when providing financial assistance to your child is the gift tax. The gift tax exists to ensure one doesn’t avoid paying estate tax by transferring their assets while they are still alive. Although it is unlikely you will ever pay gift tax, you will still need to file a gift tax return if you transfer assets to your child that are valued in excess of the gift tax exclusion. For 2018, that amount is $15,000 per individual, so you and your spouse could transfer $30,000 without having to file a gift tax return.
As I stated above, though, it is unlikely you’ll ever actually have to pay gift tax as you would need to gift $10,000,000 before gift tax would be due. Fortunately, most of us will never have to worry about plans to gift $10,000 while we’re still alive.
The last issue many parents will want to consider is how owning assets will impact eligibility for college financial aid. I’ll examine that in an upcoming post.
Micah Porter is a Decatur (Atlanta) based financial planner.