At one time, long, long ago, a common tax strategy was to shift investment income from a parent to their child (children) to take advantage of the child’s (children) lower tax bracket/rate. This planning strategy was removed with the introduction of the child tax. Like any other stopgap measure, CPAs and tax attorneys across the country found loopholes and strategies to circumvent the original child tax rules. In response, Congress continues to tighten the child tax rules. These are some of the current rules/tax planning strategies regarding the child tax.
The child tax applies to the investment income (dividends, interest, and capital gains) of a child who is:
1. Under the age of 18 at the end of the year or;
2. Age 18, unless the child’s earned income is more than 50% of your support or;
3. 19-23 years old and full-time student
When the child tax applies, the child’s investment income is taxed at the parent’s tax rate, rather than the child’s, to the extent such income exceeds $1,900 per year (as of 2009). The father has the option of reporting the kiddie tax on his individual income tax return or on the return of his (children).
Tax Planning Strategies:
1. Invest the child’s assets in property that generates tax-exempt income. For example, municipal bonds;
2. Invest the child’s assets in tax-deferred investments such as individual stocks, exchange traded funds, real estate investment trusts, variable annuities, fixed annuities, permanent life insurance, commodities, etc.
3. Invest a portion of the child’s assets in US savings bonds and choose to report interest each year. This strategy works as long as the interest on the US Savings Bonds does not exceed the threshold of $1,900;
4. If the child has earned income, invest the assets that generate taxable investment income in Roth IRAs. Qualified Roth IRA distributions are never subject to income tax.