Many people ask if they can save on taxes by transferring assets into their children’s names.
This tax technique is called income shifting. It seeks to take income out of your higher tax bracket and place it in the lower tax brackets of your children.
Some tax savings are available through this approach.
Kiddie Tax Limitations
The kiddie tax rules impose substantial limitations if:
- The child is under age 18 before the close of the tax year or
- The child is age 18 or a full-time student age 19-23 and their earned income doesn’t exceed half of their support.
The kiddie tax rules apply to your children who fall in the age ranges above and have more than $2,300 of unearned (investment) income for the tax year 2022.
While some tax savings on up to $2,300 of income for 2022 can still be achieved by shifting income to children under the cutoff age, the savings are not substantial.
Tax Year 2022 vs. Previous Years
For 2022, and later tax years, children to whom the kiddie tax rules apply— who have over $2,300 of unearned income for the tax year 2022—are taxed on that excess amount at their parents’ tax rates.
This kiddie tax is calculated by computing the “allocable parental tax” and special allocation rules apply where the parent(s) have more than one child subject to the kiddie tax.
But, for tax years beginning in 2018 and 2019, the kiddie tax was computed based on the estates’ and trusts’ ordinary and capital gain rates, instead of the parent’s tax rates.
Taxpayers can retroactively elect for 2018 and 2019 to compute kiddie tax based on the parent’s marginal rates.
This means that you may need to compute the kiddie tax for 2018 and/or 2019 under both computation methods to determine which produces a better result. And you may need to file an amended return.
Note that to transfer income to a child, you must actually transfer ownership of the asset producing the income: you can’t merely transfer the income itself.
Property can be transferred to minor children using custodial accounts under the state Uniform Gifts or Transfers to Minors Acts.
Investments with Little or No Taxable Income
The portion of investment income of a child that is taxed under the kiddie tax rules may be reduced or eliminated if the child invests in vehicles that produce little or no current taxable income.
- Securities and mutual funds oriented toward capital growth that produce little or no current income;
- Vacant land expected to appreciate in value;
- Stock in a closely held family business, expected to become more valuable as the family business expands, but which pays little or no cash dividends;
- Tax-exempt municipal bonds and bond funds;
- U.S. Series EE bonds, for which recognition of income can be deferred until the bonds mature, the bonds are cashed in, or an election to recognize income annually is made.
Investments Not Subject to the Kiddie Tax—No Taxable Income
These investments produce no taxable income and aren’t subject to the kiddie tax. Tax-advantaged savings options include:
- Traditional and Roth individual retirement accounts (IRAs and Roth IRAs), which can be established or contributed to if the child has earned income;
- Qualified tuition programs (QTPs, also known as 529 plans);
- Coverdell education savings accounts (CESAs).
A child’s earned income (as opposed to investment income) is taxed at the child’s regular tax rates, regardless of amount.
Therefore, to save taxes within the family, consider employing the child and paying reasonable compensation. This is particularly appropriate if you have your own business, but can be done even if you don’t.
Where the kiddie tax applies, it’s computed and reported on Form 8615, which is attached to the child’s Form 1040.
Parents can elect to include the child’s income on their own return, if certain requirements are satisfied. This avoids the need for a separate return for the child.
The election to include a child’s income on the parents’ return is made, and the additional taxes resulting to the parents are computed and reported, on Form 8814.
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