The Tax Cuts and Jobs Act passed last year does more than just affect your taxes; it also has the potential to trigger a hefty tax bill for a child learning to invest.
The “kiddie tax,” as it is commonly known, kicks in after a child has $2,100 of unearned income, such as investment gains. The tax affects children until they are over 18 and no longer full-time students (for full-time students, the tax applies until age 24).
That tax can really hurt if you’re teaching your child how to invest using an account that’s in the child’s name. Before the new tax law, that income was taxed at the parents’ top tax bracket; now, any investment earnings your child has are taxed at the rate for estates and trusts, which tops nearly 40 percent for income above $12,500, says Joseph A. Clark, the Anderson-Indiana-based managing partner of Financial Enhancement Group.
[See: 7 ETFs to Profit From Recent Tax Cuts.]
“Unfortunately this means that children, who may not even have much investment income, will find themselves paying tax at much higher rates than their parents,” says David J. Haas, a certified financial planner with Cereus Financial Advisors in Franklin Lakes, New Jersey. In fact, many investment vehicles for minors — such as custodian accounts under the Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) — could be subject to higher tax rates, he says. In most states, children don’t have complete control of the funds in these accounts until they are at least age 18.
Unearned income that is less than $2,100 is federally taxed at 10 percent for ordinary income or zero for qualified dividends and long-term capital gains. If the total taxable income is less than $2,600, the tax rate for long-term capital gains and qualified dividends is still zero, says Lee Reams, an enrolled agent at TaxBuzz in Newport Beach, California. You will need to file a tax return for a child who has more than $1,050 a year in unearned income.
There are ways to protect your child’s investment gains from the taxman if you know where to look. Although you could hold those investments in your name, any gains could increase your tax bill. Instead, experts have these tips for minimizing tax headaches while teaching your kids an important investing lesson — how to keep more of what they make.
Use the gift tax exclusion and invest in a low-yield fund. Federal law lets you give gifts of up to $15,000 (or $30,000 for a married couple) annually to a beneficiary without triggering the annual exclusion tax.
As long as those funds are invested in a low-yielding stock or exchange-traded fund portfolio until the kids are adults and past the kiddie tax threshold, “the child can have quite a stash without taxes being an issue,” Clark says.
Establish a Roth individual retirement account for a minor. Children of any age can use gifted money to invest in their own Roth IRA for retirement, as long as they have earned income that is at least equal to the amount they are contributing, Clark says.
Opening an individual retirement account for a minor (often called a custodial or minor IRA) is perhaps one of the most underused family wealth-building strategies, says Christopher Carosa, author of “From Cradle to Retirement: The Child IRA.” Even children under 18 can contribute to a Roth IRA as long as they earn income from a job. Because they are usually in the lowest tax bracket, children who work benefit most with a Roth rather than a traditional IRA. The Roth is funded using after-tax earnings that grow tax-free, with tax-free withdrawals in retirement. If the child does not get a W-2 or 1099 tax form for the work they did, keep records for the type of work, date of work, client and earned amounts to prove that jobs like baby-sitting and lawn mowing generated earned income.
[See: 10 Long-Term Investing Strategies That Work.]
Earned income also counts if the child works for the parents in a family business. Be sure to follow the rules: The child must do actual work and must be paid no more than a reasonable rate for similar work, Carosa says. In most states, parents can begin hiring their children when they turn 14.
Think twice, though, before naming a minor as the beneficiary of your traditional IRA when you die. The child who inherits that account must begin taking minimum withdrawals — about 3.5 percent — the year they inherit the IRA. If the IRA’s beneficiary is still a minor or a full-time student under the age of 24, the money is taxed at the highest estate and trust rates, Clark says. By converting the account to a Roth before you die, you can pay the taxes for the conversion amount at a lower rate and leave your beneficiary an account where withdrawals are tax-free (though minimum distributions are still required), Clark says.
Invest in a 529 account. Although these college savings accounts are limited to the 529 plan’s investment choices, earnings grow tax-free inside the account making them tax-efficient options for a child who is learning to invest, Haas says. The money can be withdrawn tax-free to pay for tuition and other qualified expenses such as a student’s room and board.
If the money is used for other purposes, it is subject to ordinary income tax and a 10 percent penalty. Even though the child benefits from the account, it’s still considered the parent’s money and taxed at their rate when withdrawn, Clark says. So if your child doesn’t need the money for education, the most tax-efficient use is paying school expenses for yourself or holding onto the account for your grandkids’ education expenses, he says.
[See: 7 of the Best Blue-Chip Stocks to Buy for 2018.]
Pick investments in taxable accounts carefully. If the taxable investment account (such as an UGMA or UTMA) that you’re using as a teaching tool is in the child’s name, buy a blue chip stock to hold long term. Blue chip stocks shouldn’t generate much taxable income because they pay mostly dividends and won’t produce immediate capital gains, Haas says. An actively managed mutual fund in the account, on the other hand, could be painful each April because as the manager buys and sells shares within the fund, short-and long-term gains become taxable to the fund shareholders, he says.
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How to Minimize Taxes for a Child Learning to Invest originally appeared on usnews.com
