The dreaded “Kiddie Tax” is undergoing some changes in 2018, both good and bad. For those familiar with the Kiddie Tax, rates on dependent’s investment income will no longer be subject to the parent’s marginal tax rate. For some this is welcomed news and for others there is a catch. This article will breakdown the Kiddie Tax changes for 2017 and how exactly it will impact taxpayers in 2018 and beyond …2025 if the changes aren’t extended.

Background

The Tax Reform Act of 1986, referred to as the second of the two “Reagan tax cuts,” introduced the concept of the “Kiddie Tax.” The provision was intended to eliminate the practice of shifting taxable income from high net worth individuals to their children.

Say for example Johnathan Richman is subject to the maximum capital gains rate of 20%. If he had an investment that earned $100,000 in capital gains per year then he would potentially pay $20,000 in taxes on that one account alone. But if he had 4 children then he could give each child $25,000. They would fall in the 15% tax bracket and therefore would pay no tax on their capital gains!

The government generally doesn’t appreciate individuals using loopholes to avoid taxes so Congress passed a provision specifying that a child under the age of 14 at the end of a tax year must pay tax on unearned income over a specified amount at the higher of the child’s marginal tax rate or his or her parent’s marginal tax rate. Basically, Johnathan Richman’s kids would pay the capital gains rate of 20% on a portion of their investment income even if they only earned $25,000 each.

In 2006 and 2007, the law was further expanded to cover dependents up to age 18 and even to age 23 if they are full-time students – adding more complexity to an already complex tax code. More and more taxpayers fell under the Kiddie Tax rules which greatly increased reporting requirements and complexity.

2018 Changes

For starters, the applicable threshold of $2,100 on a child’s investment income is still in effect in 2018. This means that a child’s investment income will be subject to the Kiddie Tax for investment income in excess of $2,100.

What does change is far more impactful than the $2,100 threshold on investment income. For taxable years between 2018 and 2025, Kiddie Tax rates will no longer be at the parents marginal tax rates. This is intended to reduce complexity and sever the tie between a child’s tax return and their parents in regards to investment income.

In laymen’s terms, a child’s “kiddie tax” is no longer affected by the tax situation of his or her parent, or the unearned income of any siblings.

However, there is a catch – taxable income attributable to net unearned income is taxed according to brackets applicable to trust and estates, with respect to both ordinary income and income taxed at preferential rates. So what are the tax brackets applicable to trust and estates?

As you can see by this chart, the tax brackets hit the top marginal tax rate of 39.6% fairly quickly – $12,500 to be exact. Compare that to a single individual who’s top tax rate isn’t applied until their taxable income exceeds $500,000.

However, this doesn’t mean that the Kiddie Tax will be more in 2018 than in prior year’s. If a child’s unearned income falls below $2,550 after deducting the $2,100 exclusion then their tax rate will only be 15%. Compare that to the parents potentially higher rate and you could see a small tax savings (emphasis on small).

Conclusion

With the new tax changes taking effect in 2018 it might be prudent to discuss your specific tax situation with your tax or investment advisor. Calculating the Kiddie Tax in 2018 might be simplified but it will dramatically impact your child’s tax liability.