Executive Summary
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.
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 so-called “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 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 avoid the cost/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.
However, it’s important to note that the “support” test itself for the kiddie tax is not the same as the support test for determining dependent status; for the kiddie tax, earned income must exceed at least one half of the child’s support needs (regardless of how it is spent), while dependent status is determined based on whether the child actually paid/provided for at least one-half of his/her own support (regardless of whether funded from earned or unearned income). Thus, a dependent child could still avoid the kiddie tax (but having earned income in excess of one-half of support needs, but not actually spending money on his/her own support), while a child could avoid being a dependent but still face the kiddie tax (if the child provided more than one-half of his/her own support, but had little or no earned income).
In addition to the support test (where applicable), if the child is married and files a joint tax return, the kiddie tax does not apply.
Shifting Appreciated Stock To College Students At 0% Tax Rates
So why is the presence of the kiddie tax – and the potential to avoid it – so important? Because it allows for intra-family income-shifting opportunities that can save significant tax dollars, especially in today’s environment where capital gains can be “harvested” at 0% Federal tax rates.
For instance, imagine that the parents own an investment that was originally purchased long ago for $10,000 (perhaps ear-marked for future college funding!), and has now appreciated to $25,000. If sold, the $15,000 long-term capital gain would generate a $2,250 Federal tax liability at a 15% tax rate (or more at higher capital gains tax brackets). If the parents gift the stock to the child, though, and the child sells it at his/her own tax rates, the stock may be eligible for the 0% Federal rates if the child’s overall income (including the capital gain) remains in the bottom two tax brackets. The end result: a $2,250 tax savings and a “free” capital gain (at least at the Federal level; state income taxes may still apply).
If the stock is owned in the parents’ name, it can be gifted to the child and with a gift-splitting election between husband and wife, stay under the $14,000 per year per person annual gift exclusion (in 2015). Alternatively, if the stock is already in the child’s name – e.g., in an UGMA or UTMA account – the stock (and its gains) already belong to the child, and it’s simply a matter of avoiding the kiddie tax to ensure it is taxed at the child’s 0% rates.
Notably, the fact that the child is actually earning income from wages or self employment – to avoid the scope of the kiddie tax – can push up the child’s total taxable income, potentially driving some capital gains out of the 0% rates. With the bottom two tax brackets ending at $37,450 for individuals, there may be limited room for both earned income and capital gains. Though notably, the child can claim deductions against their income, including a larger standard deduction if the child has earned income, and a personal exemption if the child actually does use their earned income and other assets to support themselves (and meet the other tests required to avoid being a qualifying child dependent on their parents’ tax return).
In fact, a child who avoids the kiddie tax and pays enough of their own support to avoid being a dependent as well may be able to claim the American Opportunity Tax Credit (AOTC) for themselves by paying for college expenses from the gifted (and earned income) resources. This $2,500 tax credit would potentially will fully offset all taxes owed from the earned income and any capital gains not eligible for 0% rates (and shifting the American Opportunity Tax Credit to the child may be especially appealing if the parents would have been over the AOTC income thresholds required for eligibility anyway!)!
Cumulatively, the potential for saving $2,250 of Federal taxes on capital gains (from income shifting), up to another $2,500 of taxes on earned income (from the American Opportunity Tax Credit), and potentially even more with a larger standard deduction and the child claiming their own personal exemption, adds up to a material amount of tax dollars, and can be repeated for several years in a row!
Avoiding The Scope Of The Kiddie Tax For College Students
For those who wish to avoid the scope of the kiddie tax and take advantage of the family gifting and tax savings opportunities, the reality is that there is little to be done for a child under the age of 18, where the kiddie tax will apply regardless of earned income and support needs. In the case of full-time college students, though, the “good” news is that the kiddie tax only applies in situations where the child fails to generate earned income equal to at least one-half of his/her support needs, which in turn means that families actually have an opportunity to avoid its scope.
Of course, the caveat to avoiding the kiddie tax for a full-time college student is that the student must actually generate earned income, which means some kind of job that generates wages or self-employment income. However, because “full-time” student status only requires attending school full time for at least five months per year, the goal of generating enough earned income to equal at least one-half of support is not necessarily insurmountable, possibly as a blend of part-time work during school and/or on campus, along with full-time work during breaks (including the long summer break).
For some families, there may even be an opportunity to employ the child within a family business, whether doing odd jobs around the company, or even “higher end” (i.e., higher paying) work like graphics or web design. As long as the work is bona fide, documented appropriately, and the children are really paid, it’s not a problem that it occurs within the family, and can even be an effective means of shifting additional income for tax savings within the family (as a payment for services rendered to the child is taxable to the child but deductible to the business, which may shift income from the parents’ or business’s tax return to the child’s). One creative business owner even paid his children a “modeling fee” for appearing in the firm’s advertising materials (given that outside models would certainly not have worked for free!). And children that have earned income can take advantage of other appealing tax savings strategies as well, like funding a Roth IRA.
Ultimately, whether it’s feasible to generate enough earned income to reach the threshold of “one-half of support” will obviously depend on the child and his/her work skills and capabilities, as well as the sheer magnitude of the threshold to reach. Because determining support includes education expenses, tuition alone may constitute the largest support expense, and for private colleges the total cost of attendance alone can add up very significantly (an average of $44,750 for a “moderate” private college in 2013-2014). On the other hand, for those going to a public university, the threshold is lower, but still a non-trivial average of $22,826 in 2013-2014 for in-state attendance. And that’s just the educational expense component of support!
On the other hand, it’s also notable that in order for the kiddie tax to apply to someone aged 19 or older, they must be a full-time student under the age of 24. Which means older students – e.g., already age 24 and in graduate school – do not face the kiddie tax. Nor do students who attend college part-time. And while it’s probably not a reason to get married, those who are married and filing a joint tax return avoid the kiddie tax as well (even if not otherwise generating enough earned income to meet the support test).
In the end, while the potential for shifting appreciated stock to take advantage of 0% capital gains tax rates is somewhat limited, both by the annual gift exclusion, the kiddie tax rules, and the size of the bottom tax brackets at which the 0% rate applies, there is still a potential to generate a material amount of tax savings over time. Even at an amount of “just” $2,250 of Federal tax savings, the cumulative tax savings can add up when repeated for several years, especially when stacked on top of the American Opportunity Tax Credit, and since such gifting can continue for many years for children who continue on from undergraduate to graduate school (where the kiddie tax will no longer apply by age 24), or even just by continuing gifts to children after graduation. Of course, for parents who have already “fully funded” college through saving to 529 plans, this may be a moot point, but for the large number of families that haven’t funded everything in advance, avoiding the kiddie tax and gifting appreciated investments instead can result in a nice tax savings opportunity!
Doesn’t gifting appreciated shares to your kids who are in a low tax bracket work regardless of what the money is used for when the gifted shares are sold? The parent obviously prefers that the gift pay for something that benefits the child in the long term. In my case, I essentially fund Roth IRAs for my kids by gifting them mutual fund shares with a low cost basis.
David,
It matters if you’re trying to avoid the kiddie tax on the sale of those low-basis gifts…
– Michael
Does this also work to a lesser degree but still significant degree, even if your child has no earned income.
For example… If you gift appreciated stock, enough to pay for over half their living expenses (including college).
They then meet the support test to file not as a dependent and can take both the standard deduction and opportunity tax credit to offset the long term capital gains.
In 2018 with the 12,000 standard deduction and the $2500 opportunity tax credit they could pay zero taxes on approximately 25k of long term capital gain… I think ?
How do the new tax laws change this information?
Does this have any other adverse consequences? For example, does it affect the eligibility of the student for medical insurance under a parent’s policy? Or eligibility for auto insurance under a parent’s policy? It seems these are age-based and based on being a full-time student, rather than being based on being claimed as a dependent on your parent’s taxes. So I don’t think they would be affected, but would like to know if there are any such considerations.
By the way, there is a small loss in doing this via the annual loss of one dependent on federal and state taxes, although that is probably much smaller than the capital gains tax savings.