Tax Filing Requirements For Minor Children with Investment Income
When parents gift money to their kids, instead of having the money sit in a savings account, often parents will set up UTMA accounts at an investment firm to generate investment returns in the account that can be used by the child at a future date. Depending on the amount of the investment income, the child may be required to file a tax return.
When parents gift money to their kids, instead of having the money sit in a savings account, often parents will set up a UTMA Account at an investment firm to generate investment returns that can be used by the child at a future date. But if the child is a minor, which is often the case, we have to educate our clients on the following topics:
How UTMA accounts work for minor children
Since the child will have investment income, do they need to file a tax return?
The special standard deduction for dependents
How kiddie tax works (taxed investment income at the parent’s tax rate)
Completed gifts for estate planning
How UTMA Accounts Work
When a parent sets up an investment account for their child, if the child is a minor, they typically set up the accounts as UTMA accounts, which stands for Uniform Transfer to Minors Act. UTMA accounts are established in the social security number of the child, and the parent is typically listed on the account as the “custodian”. As the custodian, the parent has full control over the account until the child reaches the “age of majority”. Once the child reaches the age of majority, the UTMA designation is removed, the account is re-registered into the name of the adult child, and the child now has full control over the account.
Age of Majority Varies State by State for UTMA
While the age of majority varies state by state, the age of majority for UTMA purposes and the age of majority for all other reasons often varies. For most states, the “age of majority” is 18 but the “UTMA age of majority” is 21. That is true for our state: New York. If a parent establishes an UTMA account in New York, the parent has control over the account until the child reaches age 21, then the control of the account must be turned over to their child.
$18,000 Gifting Exclusion Amount
When a parent deposits money to a UTMA account, in the eyes of the IRS, the parent has completed a gift. Even though the parent has control of the minor child’s UTMA account, from that point forward, the assets in the account belong to the child. Parents with larger estates will sometimes include gifting to the kids each year in their estate planning strategy. Each parent can make a gift of $18,000 (2024 Limit) each year ($36K combined) into the child’s UTMA account, and that gift will not count against the parent’s lifetime Federal and State lifetime estate tax exclusion amount.
A parent can contribute more than $18,000 per year to the child’s UTMA account, but a gift tax return may need to be filed in that year. For more information on this topic, see our video:
Video: When You Make Cash Gifts To Your Children, Who Pays The Tax?
When Does The Minor Child Need To File A Tax Return?
For minor children that have investment income from a UTMA account, if they are claimed as a dependent on their parent’s tax return, they will need to file a tax return if their investment income is above $1,250, which is the standard deduction amount for dependents with unearned income in 2024.
For dependent children with investment income over the $1,250 threshold, the investment is taxed at different rates. Here is a quick breakdown of how it works:
$0 - $1,250: Covered by standard deduction. No tax due
1,250 - $2,500: Taxed at the CHILD’s marginal tax rate
$2,500+: Taxed at the PARENT’s marginal tax rate (“Kiddie tax”)
How Does Kiddie Tax Work?
Kiddie tax is a way for the IRS to prevent parents in high-income tax brackets from gifting assets to their kids in an effort to shift the investment income into their child’s lower tax bracket. For children that have unearned income above $2,500, that income is now taxed as if it was earned by the parent, not the child. This applies to dependent children under the age of 18 at the end of the tax year or full-time students younger than 24.
IRS Form 8615 needs to be filed with the child’s tax return, which calculates tax liability on the unearned income above $2,500 based on the parent's tax rate. A tax note here: in these cases, the parent’s tax return has to be completed before the child can file their tax return since the parent’s taxable income is included in the Kiddie tax calculation. In other words, if the parents put their tax return on extension, the child’s tax return will also need to be put on extension.
Unearned vs Earned Income
This article has focused on the unearned income of a child; if the child also has earned income from employment, there are different tax filing rules. The earned income portion of the child’s income can potentially be sheltered by the $14,600 (2024) standard deduction awarded to individual tax filers.
This topic is fully covered in our article: At What Age Does A Child Have To File A Tax Return?
Investment Strategy for Minor Child’s UTMA
Knowing the potential tax implications associated with the UTMA account for your child, there is usually a desire to avoid the Kiddie tax as much as possible. This can often drive the investment strategy within the UTMA account to focus on investment holdings that do not produce a lot of dividends or interest income. It’s also common to try to avoid short-term capital gains within a child’s UTMA account since a large short-term capital gain could be taxed as ordinary income at the parent’s tax rate.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Kiddie Tax & Other Pitfalls When Gifting Assets To Your Kids
Before you gift assets to your children make sure you fully understand the Kiddie Tax rule and other pitfalls associated with making gift to your children……….
There are a number of reasons why parents gift assets to their kids which include:
Reduce tax liability
Protecting assets from the nursing home
Estate planning: Avoiding probate
But the pitfalls are many and most people do not find out about the pitfalls until it’s too late. These pitfalls include:
Kiddie tax rules
Children with self-directed investment accounts
Treatment of long-term capital gains
Gifting cost basis rules
College financial aid impact
Control of the assets
5 Year look-back rule
Divorce
Lawsuits
Distributions from Inherited IRA’s
Kiddie Tax
The strategy of shifting assets from a parent to a child on the surface seems like a clever tax strategy in an effort to shift investment income or capitals gains from the parent that may be in a high tax bracket to their child that is in a low tax backet. Unfortunately, the IRS is aware of this strategy, and they have been aware of it since 1986, which is the year the “Kiddie Tax” was signed into law.
Here is how the Kiddie tax works; if your child’s income is over a certain amount, then the income is taxed NOT at the child’s tax rate, but at the PARENT’S tax rate. Kiddie tax rules do NOT apply to earned income which includes wages, salary, tips, or income from self-employment. Kiddie tax ONLY applies to UNEARNED INCOME which includes:
Taxable interest
Dividends
Capital gains
Taxable Scholarships
Income produced by gifts from grandparents
Income produced by UTMA or UGMA accounts
IRA distributions
There are some exceptions to the rule but in general, your child would be subject to the Kiddie tax if they are:
Under the age of 19; or
Between the ages of 19 and 23, and a full-time student
The only exceptions that apply are if your child:
Has earned income totaling more than half the cost of their support; or
Your child files their tax return as married filing joint
Kiddie Tax Calculation
Here is how the Kiddie tax calculation works. For 2022, the first $1,150 of a child’s unearned income is tax-free, the next $1,150 is taxed at the child’s rate, and any unearned income above $2,300 is taxed at the parent’s marginal income tax rate.
Here is an example, the parents bought Apple stock a long time ago and the stock now has a $30,000 unrealized long term capital gain. Assuming the parents make $200,000 per year in income, if they sell the stock, they will have to pay the Federal 15% long term capital gains tax on the $30,000 gain. But they have a child that is age 16 with no income, so they gift the stock to them, have them sell it, with the hopes of the child capturing the 0% long term cap gains rate since they have no income. Kiddie tax is triggered!! The first $2,300 would be tax free but the rest would be taxed at the parent’s federal 15% long term cap gain rate; oh and if that family was expecting to receive college financial aid two years from now, they might have just made a grave mistake because now that teenager is showing income. A topic for later.
That was an example using long term capital gains rates but if we used a source of unearned income subject to ordinary income tax rates, the jump could go from an assumed 0% to the parents 37% tax rate if they are in the highest fed bracket.
Putting Your Kids on Payroll
While we are on the subject of Kiddie Tax, our clients that own small businesses will sometimes ask “Do I have to worry about the Kiddie tax if I put my kids on payroll through my company?” Fortunately the answer is “No”. Paying your child W2 wages through your company is considered “earned income” and earned income is not subject to the kiddie tax rules.
Children with Self-Directed Investment Accounts
It’s becoming more common for high school and college students to have their own brokerage accounts where they are trading stocks, ETFs, options, cryptocurrency, and mutual funds. But the kiddie rules can come into play when they are buying and selling investments in their accounts. If the parents claim the child as a dependent on their tax return and they buy and then sell an investment within a 12 month period, that would create a short term gain subject to ordinary income tax rates. If that gain is above $2,300, then the kiddie tax is triggered, and the gain would be taxed at the parent’s tax rate not the child’s tax rate. This can lead to tax surprises when the child receives the tax forms from the brokerage platform and then realizes there are big taxes due, and the child may or may not have the money to pay it.
For the child to file their own tax return to avoid this Kiddie tax situation, the child must be earning enough income to provide at least half of their financial support.
Kiddie Tax Form 8615
How do you report the Kiddie tax on your tax return? I spoke with a few CPA’s about this and they normally advise their clients that once the child has unearned income over $2,300, the child, even though they may be a dependent on your tax return, files their own tax return, and with their tax return they file Form 8615 which calculates the Kiddie Tax liability based on their parent’s tax rate.
Impact on College Financial Aid
Before gifting any assets to your child, income producing or not, if you are expecting to receive any form of need based financial aid for your child for college in the future, be very very careful. The FAFSA calculation weighs assets and income differently depending on whether it belongs to the parent or the child.
For assets, if the parent owns it, the balance counts 5.64% against the aid awarded. If the child owns it, the balance counts 20% against the aid awarded. You move a stock into your child’s name that is worth $30,000, if you would have qualified for financial aid, you just cost yourself $4,300 PER YEAR in financial aid.
Income is worse. If you gift your child an asset that produces income or capital gains, income of the parents counts 22% - 47% against college financial aid depending on the size of the household. If the income belongs to the child, it counts 50% against the FAFSA award. Another note, the FAFSA process looks back 2 years for purposes of determining the financial aid award, so even though they may only be a sophomore or junior in high school, you don’t find out about that mistake until 2 years later when they are applying for FAFSA as a freshman in college.
Long Term Capital Gains Treatment
The example that I used earlier with the Apple stock highlights another useful tax lesson. If you are selling a stock, mutual fund, or investment property that you have owned for more than a year, it’s taxed at the preferential long term capital gain rate of 15% as long as your taxable income does not exceed $459,750 for single filers or $517,200 for married filing joint in 2022, it’s a flat 15% tax rate whether it’s a $20,000 gain or a $200,000 gain because the rate does not increase like it does for “earned income”. I make this point because long term capital gain rates are already taxed at a relatively low rate, and if realized by your child, are subject to Kiddie tax so before you jump through all the hoops of making the gift, make sure the tax strategy is going to work.
Gift Cost Basis Rules
When you make a gift, it’s important to understand how the cost basis rules work. When you make a gift, there typically is not an immediate tax event, but the recipient inherits your cost basis in that asset. Gifting an asset does not provide the person making the gift with a tax deduction or erase the unrealized gains, unless of course you are gifting it to a charity or not-for-profit. Let’s keep running with that Apple stock example, you gift the Apple stock to your child with a $30,000 unrealized gain, there is no tax event when the gift is made, but if the child sells the stock the next day, they will have to pay tax on the $30,000 realized gain, and if the kiddie tax applies, it will be taxed at the parent’s tax rate.
Estate Tax Planning: Avoid Probate
Sometimes people will gift assets to their kids in an effort to remove those assets from their estate to avoid probate, a big tax issue surfaces with this strategy. Normally when someone passes away and their kids inherit a house or investments, they receive a “step-up in basis”. A step-up in basis means no matter what the gain was in the house or investment prior to a person passing away, the cost basis to the person that inherits the assets is now the fair market value of that asset as of decedent’s date of death.
Example: You bought your house 20 years ago for $200,000 and it’s now worth $400,000. If you were to pass away tomorrow and your kids inherit your house, they receive a step-up in basis to $400,000 so if they sell the house the next day, they have no tax liability. A huge tax benefit.
But if you gift the house to your kids while you are still alive in an effort to avoid the probate process, your kids now lose the step-up in cost basis because the house never passes through your estate. If you kids sell your house the next day, they will realize a $200,000 gain and have to pay tax on it which at the Federal level of 15%, could cost them $30,000 in taxes which could have been avoided.
There are other ways to avoid probate besides gifting that asset to your kids which allows the asset to avoid the probate process and receive a step up in basis. You could setup a trust to own the asset or change the registration on the account to a “transfer on death” account.
Distributions From An IRA Owned By The Child
If your child inherits an IRA, they may be required to take RMD’s (required minimum distributions) each year from the IRA. Distribution are not only subject to ordinary income tax but they are also subject to Kiddie tax since IRA distributions are considered unearned income. If you child inherits a pre-tax IRA or 401(k) be very careful when taking distribution from the account, especially taking into consideration the new distribution rules for non-spouse beneficiaries.
Control of the Asset
As financial planners, we have seen a lot of crazy things happen. While some teenagers are very responsible, others are not. When you gift an asset directly to child, they may not use that gift as intended. Even with UTMA and UGMA account, the parents only have control until the child reaches age of majority, and then account belongs to them. If there is any concern about how the gifted asset will be managed or distributed, you may want to consider a trust or another type of account that provides the you with more control of the asset.
Lawsuits
From a liability standpoint, if you gift assets to your child, and those assets have a meaningful amount of value, those assets could be exposed to a lawsuit if your child were to ever be sued.
Divorce
If you gift assets to your child and they are already married or get married in the future, depending on what state they live in or how those assets are titled, they could be considered marital property. If a divorce happens at some point in the future, their soon to be ex-spouse could now be entitled to a portion of those gifted assets.
5 Year Lookback Rule
Some parents will gift assets to their children to avoid the spend down process should a long term care event happen at some point in the future and they need to go into a nursing home. Different states have different Medicaid rules but in New York, the gift has to take place 5 years prior to the Medicaid application otherwise the assets are subject to spend down.
The other pitfall of gifting assets to your children is that while you may be able to successfully protect those assets from a Medicaid lookback period, the cost basis issue that we discussed earlier still exists. If you gift the house to your kids, they inherit your cost basis, so when they go to sell the house after you pass, they have to pay tax on the full gain amount, versus if you established a grantor irrevocable trust to own your house, it could satisfy the gift for the 5 year look back period in NY, but then your kids receive a step up in basis when you pass away since the house passes through your estate, and they can sell the house with no tax liability.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
At What Age Does A Child Have To File A Tax Return?
When your children begin working and they receive their first W2, the question from parents is often “Do they have to file a tax return?” In this video we will cover
When your children begin working and they receive their first W2, the question from parents is often “Do they have to file a tax return?” In this video we will cover:
At what age are you required to file a tax return
The $12,400 income threshold
Tax refunds for children
Impact on the IRS Stimulus Checks
Can you still claim them as a dependent if they file a tax return?
Kiddie Tax
DISCLOSURE: This is for educational purposes only. This is not tax advice. For tax advice, please consult your tax professional.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.Money Smart Board blog
