In the past, many parents have tried to reduce their own tax bill by transferring income-generating investment assets into custodial accounts they establish for their minor children.
Since most children’s marginal tax rates are significantly lower than those of their parents, shifting these assets to their kids' accounts would theoretically help parents avoid having to pay higher taxes on income generated by these assets.
The IRS’s kiddie tax is designed to limit parents’ ability to exploit this loophole.
Kiddie tax rate thresholds
The kiddie tax applies to unearned income, such as income and capital gains generated by custodial accounts in the names of dependent children age 18 or younger (or full-time students younger than 24).
Over the past few years, kiddie tax rules have been revised several times. At the moment, kiddie tax rates and thresholds follow mandates established under the SECURE Act of 2020:
- Unearned dependent-child income that is $1,150 or less is exempt from federal income taxes.
- Unearned dependent-child income between $1,151 and $2,299 is taxed at the child's marginal tax rate.
- Any amount over $2,300 is taxed at the parents' marginal tax rate.
Reducing the impact of kiddie taxes
There are several strategies that may help you reduce or avoid the generation of kiddie-taxable unearned income.
- Consider investing your child’s money in securities that potentially generate tax-exempt income, such as municipal bonds*; investments that defer tax, such as U.S. savings bonds; or growth-oriented stocks and growth securities that don’t declare dividends.
- Try to avoid selling appreciated stocks owned less than a year, since these profits are taxed as ordinary income. Profits on the sale of stocks owned more than a year are taxed at more favorable long-term capital gains tax rates.
- Consider reporting interest income from U.S. savings bonds in a child’s name in years when the amount won’t push your child’s total unearned income over the kiddie-taxable threshold.
The Minor Roth IRA option
If your child has earned income from a part-time job or side business, consider moving some kiddie-tax generating assets from their taxable investment accounts into a Minor Roth IRA established on their behalf.
Income earned each year in a Roth IRA isn’t subject to federal income taxes. More importantly, qualified Roth IRA distributions generally aren’t taxable as long as:
- Your child doesn’t start taking distributions until age 59½ or older.
- The Roth IRA has been established for at least five years.
Keep in mind that Roth IRA contributions must be made on an after-tax basis and are not tax-deductible. Annual contributions can’t exceed a minor's yearly earned income. For example, if your child earns $2,000 this year from their dog-walking business, their maximum Roth IRA contribution is $2,000. The annual maximum IRA contribution limit for 2023 is $6,500.
And when your child reaches the age of maturity in your state (usually between 18-21), you must transfer ownership of the Minor IRA to them.
If you have questions about any of these strategies, consult with your professional tax advisor or financial advisor.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.
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Dan Flanagan is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or dflanagan@canbyfinancial.com.
*Municipal bonds are federally tax free but may be subject to state and local taxes, and interest income may be subject to the federal alternative minimum tax (AMT).
© 2023 Commonwealth Financial Network® and Canby Financial Advisors.