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The winners and losers from the new Kiddie Tax

The Wall Street Journal. logo The Wall Street Journal. 7/20/2018 Laura Saunders

Parents and grandparents, beware: The latest version of America’s “Kiddie Tax” will raise the cost of giving sharply in some cases.

The Kiddie Tax is a special levy on a child’s “unearned” income above $2,100. It typically falls on investment income such as dividends, interest and capital gains, and it doesn’t apply to a youngster’s earned income from mowing lawns or designing websites.

Congress passed the Kiddie Tax in 1986 to prevent wealthy or affluent taxpayers from taking advantage of their children’s lower tax rates by shifting income-producing assets to them. Originally the provision was for children under age 14, but lawmakers expanded it over time.

Today, the Kiddie Tax applies to nearly all children under 18 and many who are under 24, if they are full-time students and aren’t self-supporting.

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For 2015, about 343,000 children paid a total of $1 billion in Kiddie Tax, according to the latest Internal Revenue Service data.

Last year’s overhaul made an important change to the rates for this tax. Beginning this year and continuing through 2025, when the law sunsets, a child’s unearned taxable income will be subject to trust tax rates. Under prior law, this income was usually taxed at the parents’ rate.

This means Kiddie Tax will be far simpler. The prior version often required families to combine the unearned income of siblings, figure tax at the parents’ rate, and spread the tax among the children. Now siblings’ earnings are separate, and there’s no need for awkward conversations in which parents must reveal their own income to children so the children can file returns.

But there will be surprises from this rate shift. For example, the threshold for the 20% capital-gains rate is now $12,700 under the trust tax rates, compared with more than $400,000 last year.

The effects of these changes will vary.

“The new Kiddie Tax will often be lower or the same for children of high-income parents, but it could rise for children of parents in lower brackets,” says Tim Steffen, a tax specialist with Robert W. Baird & Co.

He offers an example. Say a full-time college student has a high-earning grandparent, and his parents have taxable income of about $150,000. To help with tuition, the grandparent gives the student stock to sell that has a long-term gain of $40,000.

Under last year’s Kiddie Tax, the grandson would have owed tax of nearly $5,700 because his parents’ capital-gains rate was 15%. Under the new law, his tax bill will rise to nearly $6,600, because a chunk of the gain is now taxed at the top rate of 20%.

Mr. Steffen says that to reduce taxes under the new law, the grandparent should give the stock to the parents instead of the student and let them sell it. Then the tax rate would be 15%.

At the same time, many children of top-bracket taxpayers will be winners under the new law, says Mr. Steffen. If such a child has $4,000 of interest or a payout from an inherited individual retirement account, her Kiddie Tax bill would have been about $860 last year. This year it drops to about $300, due to lower rates for trusts.

The bottom line is that generous parents, grandparents and others need to take a new look at income-tax effects before making gifts to young people. Here’s more to consider.

It’s not just investment income. The Kiddie Tax also applies to unearned income from sources other than a child’s investments, such as from an inherited traditional IRA or 401(k), a taxable legal settlement or, in a few cases, Social Security survivor benefits.

Thus, it’s often better leave a child a Roth IRA, which can make tax-free payouts, rather than a traditional IRA or 401(k), if the child would owe Kiddie Tax on the payouts.

Choose investments carefully. The first $1,050 of a child’s unearned income is typically tax-free because of a standard deduction. The next $1,050 is often taxed at a low rate—although specialists say the new law is unclear as to whether it will be the child’s own rate or the trust tax rate.

This $2,100 total can go a long way. It could largely shelter the current annual dividend from, say, $100,000 invested in an S&P 500 index fund.

The dividends from stock in a single company could also be less than $2,100 a year. But if the company undergoes a taxable merger and there’s a large capital gain, that could trigger Kiddie Tax.

A day makes a difference. The Kiddie Tax doesn’t apply to children who are 24 or older or who are married. Some part-time students also don’t owe it, and there are other exceptions.

Suzanne Shier, chief tax strategist at Northern Trust Co., advises young people, “Don’t sell a gift of stock immediately in a knee-jerk reaction. Check the taxes first.”

Write to Laura Saunders at laura.saunders@wsj.com

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