MAKING CENTS: Avoiding the kiddie tax

pic source: hellenmilleronine.com

Under the kiddie tax rules, children under age 20 and full-time students living with their parents will pay income taxes at the parents’ highest marginal tax bracket on all unearned income above $2,000 in 2013.

This rule isn’t new, but it has even greater impact under the higher rates we all will pay on unearned income and capital gains starting this year. The IRS made these rules in the 1980s to curb a common tax reduction strategy of shifting investment assets into the children’s names to pay less in taxes.

Unearned income includes any type of investment income, whether from banks, stocks, bonds, mutual funds or real estate. On the first $1,900 in 2012 and $2,000 in 2013, these children will pay taxes at their own, presumably lower tax bracket. But for any unearned amounts in excess of the threshold amounts, the tax due will be calculated at the parents top marginal tax bracket. That could be as high as 44 percent in 2013. Any income the child earns from employment will be taxed at the normal income tax rate for that child.

Avoiding the kiddie tax is very difficult, but there are a few strategies that you may wish to consider.

The first is to simply make sure that the unearned income does not exceed $1,900. This is done by limiting gifts to kiddies to those assets that are non-interest bearing or dividend paying. There are plenty of securities that do not pay dividends and plenty of other asset classes, such as raw land, that create no income. The theory here is that any possible future appreciation may be taken in the form of lower taxed gains on the child’s return up to $2,000 while under the age limit. After the age limit, the child can sell whatever they want and pay at their own rate.

If the assets to be gifted are for future college expenses, consider the use of a 529 savings account. In these accounts, all gains and income are tax deferred, and then tax free if used to pay for qualified educational expenses. A further benefit of the 529 account is that the grantor can control the assets leaving the child beneficiary not in control of the assets.

U.S. Savings Bonds may have a similar tax benefit. The income tax on the interest from U.S. Savings Bonds can be deferred until the bonds are . If the redemption occurs after the age threshold is reached, the bonds can be cashed in at the adult child’s own tax bracket.

A final word of caution about having assets in a child’s name; when that child reaches age 18 or 21 they are free to do what they want with the money. Obviously this may be too tempting for some children to pass up, and care should be taken to protect the assets. Consider the use of a trust with the parent or some other mature individual as the trustee. Now the parent controls the flow of the money and the associated tax consequences of any distributions to the child.

John P. Napolitano is CEO of U.S. Wealth Management in Braintree, Mass., and 2012 president of the Financial Planning Association of Massachusetts. He may be reached at jnap@uswealthmanagement.com or on Facebook as JohnPNapolitano and US Wealth

John Napolitano is a registered principal with and securities offered through LPL Financial. Member FINRA/SIPC. He can be reached at 781-849-9200.

Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through U.S. Financial Advisors, a registered investment advisor and separate entity from LPL Financial. The LPL Financial Registered Representatives associated with this site may only discuss and/or transact securities business with resident of the following states: AL, AR, AZ, CA, CO, CT, DC, FL, GA, HI, IA, ID, IL, IN, KS, KY, LA, MA, MD, ME, MN, NC, ND, NH, NJ, NM, NV, NY, OH, OK, OR, PA, RI, SC, TN, TX, UT, VA, VT, WA, WV. USFA, and U.S. Insurance Brokers, LLC are wholly-owned subsidiaries of U.S. Wealth Management. U.S. Wealth Management companies are not affiliated with LPL Financial.

The information being provided is strictly as a courtesy. When you link to any of the web sites provided here, you are leaving this web site. We make no representation as to the completeness or accuracy of information provided at these web sites. Nor is the company liable for any direct or indirect technical or system issues or any consequences arising out of your access to or your use of third-party technologies, web sites, information and programs made available through this web site. When you access one of these web sites, you are leaving our web site and assume total responsibility and risk for your use of the web sites you are linking to.