The “kiddie tax” isn’t just for kids anymore. Due to recent tax law changes, investment income earned by a child may continue to trigger the additional tax well into his or her 20s. This can put a damper on traditional college savings techniques for children.
Strategy: Establish a “minor’s trust,” also called a Section 2503(c) trust, for kids or grandkids. With this type of trust, all of the income is taxed directly to the trust. In other words, the kiddie tax never comes into play.
A minor’s trust has at least one distinct advantage over the better-known option of a custodial account. Reason: The trust can continue past the age of majority in the state where the family lives.
Therefore, there are no worries about children squandering the funds in their accounts. And, if you’re the trustee, you can still call the shots for the trust all the way to graduation day. It’s a win-win situation.
Benefits of a trust
Here’s the whole story: When you set aside funds for children, say, to save for their future college education, the kiddie tax often erodes the earnings. This tax kicks in once the unearned income of a young child exceeds an annual threshold ($1,900 for 2011). The excess is taxed at the highest marginal tax rate of the child’s parents regardless of the source of the income.
Prior to 2006, the kiddie tax only applied to children under the age of 14. But the threshold has been gradually raised. Under current law, it generally applies to a child under age 19 or a full-time student under age 24.
So, instead of the child’s income being taxed at relatively low tax rates, as low as 10%, a large chunk of income could be taxed at rates reaching up to 35% (see box below).
Income earned in a child’s custodial account is subject to the kiddie tax, even if it was established under the state’s Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Plus, the account is legally turned over to the child when he or she reaches age 18 or 21.
Extra benefit: You can structure a minor’s trust so that it automatically continues beyond the age of majority if the child doesn’t exercise a limited right to withdraw the funds. This exercise period can be as short as one month.
Avoid gift tax problems
Any transfers to the trust are subject to gift tax, but that’s easy to navigate around. With the annual gift tax exclusion, a parent can give each child or grandchild up to $13,000 a year (in 2011) without paying any gift tax. Furthermore, the annual exclusion is doubled for joint gifts made by a married couple.
This idea makes even more “dollars and sense” if the children or grandchildren are infants. Make the gifts right now; then sit back and watch the savings grow over time.
Tip: Think twice about naming yourself as trustee of a minor’s trust. If you do, the funds will be included in your taxable estate if you die before the trust ends. Instead, name someone else, possibly a professional advisor, as the trustee.
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