Generational Financial Planning Within The Kiddie Tax Limits

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The kiddie tax (or “Tax for Certain Children Who Have Unearned Income” as the IRS calls it) is a set of tax laws which force unearned income over a small amount to be taxed at the higher tax rate of the parents. For 2017, the kiddie tax limits allows $1,050 to be received without being taxed and the next $1,050 to be taxed at the child’s rate, while any unearned income in excess of $2,100 is taxed at the parent’s top marginal rate.

This tax can cause the children of wealthy parents to lose any preferential treatment of qualified dividend income and be taxed at a rate higher than that of a multimillionaire. It can also require parents to have to disclose their tax return to their children until age 24. While it is a terrible tax policy, it is a law within which tax planning must be done.

This legislation may cause some parents to avoid generational financial planning altogether. But a more tax savvy reaction may be to determine the size and mix of a taxable portfolio which would keep unearned income under the kiddie tax limits and place accordingly to take advantage of what little room is available.

Since a balanced portfolio may have a dividend yield of about 2.1%, a portfolio of $100,000 might produce unearned income of about $2,100. Since the IRS adjusts the $2,100 limit each year, a family engaging in generational financial planning might want to gift at least enough to their children to take advantage of this amount. Here is the amount at each age which might grow to an inflation adjusted $100,000 if the investments grow by 6.5% real return over inflation:

Age Grows to $100,000
 0  $22,060
1 $23,494
2 $25,021
3 $26,648
4 $28,380
5 $30,224
6 $32,189
7 $34,281
8 $35,510
9 $38,883
10 $41,410
11 $44,102
12 $46,968
Age Grows to $100,000
13 $50,021
14 $53,273
15 $56,735
16 $60,423
17 $64,351
18 $68,533
19 $72,988
20 $77,732
21 $82,785
22 $88,166
23 $93,897
24 $100,000

If the child’s taxable brokerage account exceeds these amounts, it is more likely that a dividend yield of 2.1% could produce sufficient unearned income to trigger some kiddie tax. If the child’s portfolio remains under these amounts it is less likely that by age 24 the child’s unearned income would be triggering the kiddie tax.

Putting some investable assets in the name of the child can currently shelter $2,100 of unearned income from the tax rate of the parents. Putting too much in the name of the child can trigger the kiddie tax. Putting just the right amount could be the optimum tax savings.

Here are some additional tax savings ideas:

  1. If the family assets are over the estate planning limits ($5.49 million per individual and therefore $10.98 million for a married couple), then gifting the maximum $14,000 to each child or even grandchild every year is probably warranted. In this case avoiding the estate tax provides a greater tax savings than avoiding the kiddie tax.
  2. An average dividend yield for a diversified portfolio might be 2.1% but this can be adjusted by changing the asset allocation. Vanguard S&P 500 ETF (VOO) has a yield of 1.86%. Vanguard FTSE Energing Markets ETF (VWO) has a yield of 2.25%. But the Schwab US Large-Cap Growth ETF (SCHG) has a yield of just 0.93%. If the unearned income from a child’s portfolio looks like it will begin exceeding the limits, the investment mix can be adjusted.
  3. An all stock portfolio could appreciate at about 6.5% over inflation. The portion of growth which is not dividend yield will experience capital appreciation. Realizing this capital appreciation is best deferred until after the child is out from under their parents tax rate.
  4. When you initially begin gifting assets to the child, you can gift mildly appreciated stock. When the child sells the appreciated stock, they can shelter $2,100 of combined capital gains and interest and dividends. As an example, if your first gift is $14,000 of appreciated stock with a cost basis of $11,900 the child can sell the stock and realize $2,100 of capital gains.
  5. A child’s earned income is not subject to the kiddie tax. Hiring children willing to work for the family business is one of the best ways to engage in generational financial planning. In addition to earning income, they can put $18,000 in the company 401(k) and an additional $5,500 in a Roth IRA sheltering up to $23,000 from all future taxes. If the child has built up money in a taxable investment account, that money can be used as spending money while sheltering as much of the earned income as possible. Spending down an investable account is one method of reducing the effects of the kiddie tax.

Families that consider generational financial planning techniques can reduce the burden of taxes on the family as a whole.

Photo used here under Unsplash Creative Commons Zero.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818…)