Tax Strategies: Tax Strategies for Minors

Investments / Tax Strategies: Tax Strategies for Minors

When children under the age of 19, or under age 24 and a full-time student eligible to be claimed as a dependent on their parents' tax return, have unearned income over $1,900,¹ it is taxed at the parents' top marginal rate, unless the child is in a higher bracket. This is known as the "kiddie tax." The first $1,900 is treated as follows:

1. There is no tax on the first $950²
2. The next $950³ is taxed at the child's rate (usually 10% or 15%).

Portfolio Allocation
It is important to maximize after-tax returns in your custodial accounts. If the accounts will receive more than $1,900⁴ in income, you need to account for the kiddie tax in your investment planning. The investments shown below may help you accomplish a custodial account's goals while minimizing the child's tax liability.

For children under the age of 19 or full-time student under age 24:

• Consider any equity investment that produces low current income but has long-range growth potential, which can be realized after the child reaches age 19 or is no longer a full-time student.
  
  
• Consider municipal bonds and municipal unit trusts, which generate federally tax-exempt income. Generally, municipal interest is exempt from state and local taxes as well, if the bonds are issued in the taxpayer's home state. Keep in mind some investors may be subject to federal alternative minimum tax.
  
  
• Municipal zero coupon bonds also generate tax-free interest income that is payable at maturity, thereby eliminating the need for reinvestment decisions during the life of the bond.⁵

Income Shifting to Custodial Accounts
For children age 19 or older and not a full-time student, consider income investments including high-yield mutual funds, and other investments that generate dividends, interest, and short-term capital gains to benefit from the child's tax rates.

A popular strategy traditionally used by individuals to reduce taxes entails the shifting of investment income to family members in lower tax brackets. Income shifting not only reduces taxes on your income in general, but may also serve as a means to fund your children's or grandchildren's educational expenses. Please bear in mind that this gift is irrevocable.

Children age 19 or older, and not full-time students, pay taxes at their rate, not their parents' rate. This tax rate applies to all income realized during the calendar year the child reaches age 19, regardless of the date of his or her actual birthday. Accordingly, parents do not have to wait until the child's actual birthday to give assets and shift the income to the child's lower bracket for the child's 19th year.

Income shifting is more attractive for appreciated assets because of the 0% long-term capital gains tax rate that applies to taxpayers in the 10% or 15% tax bracket through 2010. You cannot, however, transfer the loss in an asset that has gone down in value since you acquired it.

¹ For 2012. This figure is subject to adjustment for inflation.
² For 2012. This figure is subject to adjustment for inflation.
³ For 2012. This figure is subject to adjustment for inflation.
⁴ For 2012. This figure is subject to adjustment for inflation.
⁵The market value of zero coupon bonds fluctuates more with changes in market conditions than regular coupon bonds and, therefore, may not be suitable for all investors.