How to Use the Children’s Standard Deduction to Your Advantage

During tax season, a common question we hear from clients is, “How will custodial account income from my children’s accounts be treated for taxes?” The answer is that it depends on how much income was realized over the course of the year, if they have earned income from work, and whether Kiddie Tax comes into play.

While we are not tax experts and cannot give specific tax advice, we do want to explore this topic and explain what Kiddie Tax is so that others can be more aware of how a minor’s passive income is taxed and the options available for filing (or not filing) tax returns on their behalf.

What is Kiddie Tax?

Kiddie tax is a special tax provision that applies to minors and dependents who have passive income from capital gains, dividends, interest, and other sources. It applies to dependent children 18 or younger and full-time student dependents younger than 24. Kiddie tax states that for these individuals, income derived from unearned sources is taxed at the following rates for 2022 / 2023:

• The first $1,150 is not taxed (via the standard deduction).

• The next $1,150 is taxed at the child’s tax rates.

• Anything above $2,300 is taxed at the parent’s marginal tax rate.

Note: The calculation if a dependent has earned income is more complex as they can elect either the $1,150 standard deduction or the amount of earned income + $400 as their standard deduction (up to $13,850 for 2023 as a single standard deduction).

The idea behind the Kiddie Tax was to deter parents from shifting assets to their children for the sole purpose of taking advantage of their children’s low tax brackets. The rule instead reapplies the parent’s marginal rate to any child’s unearned income above the $2,300 threshold each year.

How Can You Use this to Your Advantage?

Maximize Dependent’s Standard Deduction Each Year

If your child does not have earned income for the year and has custodial assets, they should actively seek to realize at least $1,150 of income each year. This $1,150 of standard deduction is a use or lose it deduction each year. For example, if a child had received $300 of dividends for the year and has a stock with a $1,600 unrealized capital gain, they could sell half of the stock position to create capital gains income of $800, allowing them to realize that income tax free. If the stock is sold over 2 years, the income could be received tax free from using the deduction each year. Even better, dependents with income less than $1,150 for the year are not required to file tax returns.

Gift Appreciated Assets to Children

If your child does not have gains to realize, consider gifting an appreciated position to them and then sell the asset once it is in their name. For example, if the parents own a stock worth $5,000 with a basis of $4,000, they could gift that $5,000 to the child’s UTMA account which also transfers the basis to them. Then the child can sell the position and realize the $1,000 capital gain without owing taxes (dependent upon their other income). The savings is the difference between the parent’s capital gains rate and the child’s, which might be several hundred dollars depending upon the parent’s ordinary and capital gains tax rates.

Consider Paying the Tax at the Child’s Rate

Realizing taxable income in that area between $1,150 and $2,300 of income may be beneficial too. The child’s tax rate will likely be 10% or lower (dependent upon the type of income realized) which is often superior to the parents’ capital gains rates or marginal tax rates. The key here is to avoid going over the limits where the unearned income would once again be subject to parents’ marginal rates. Also, if a dependent has more than $1,150 of unearned income, they are supposed to file a tax return even if taxes are not due for the year under the Filing Requirements for Dependents. Or, a parent can elect to include unearned dependent income on their own tax return if desired.

We are a financial advisory firm in La Jolla, California. If you are experiencing questions related to your wealth and you are looking for financial advice, please contact us.

Disclosures

The information contained in this blog is general in nature and can not be interpreted as financial or tax advice specific to any one situation. For such advice contact a financial advisor or CPA.

CONTRIBUTOR

Andrew Hoffarth, CFP® is a Lead Advisor with Financial Alternatives. When he’s not enjoying outdoor activities with his family, he excels at finding solutions for complex financial situations, allowing successful families to focus on what is most important to them. Schedule a time to chat with Andrew.