Wealth Planning Across the Ages

Wealth Planning Across the Ages

How to minimize the “kiddie tax” impact

For every action, there’s an equal and opposite reaction–This is a well-established law of physics that seems to have strong applicability within the realm of tax planning with wealth management aims. One excellent example of this can be found in the so-called “kiddie tax,” which essentially was set in reaction to a common tax reduction strategy among high-net-worth (HNW) families of shifting investment assets into one’s children’s names to pay less in taxes.

Under the kiddie tax rules, children under age 20 and full time students living with the parents will pay income taxes at the parents highest marginal tax bracket on all unearned income above $2,000 in 2013.  This tax rule isn’t new–it was first created during the 1980s–but it has even greater impact under the higher rates we all will pay on unearned income and capital gains starting this year.

 

Unearned Income

First and foremost, let’s clarify the facts: Unearned income includes any type of investment income, whether from banks, equities, debt or real estate.  On the first $1,900 in 2012 and $2,000 in 2013, these children will pay taxes at their own, presumably lower tax bracket.  But for any unearned amounts in excess of the threshold amounts, the tax due will be calculated at the parents’ top marginal tax bracket.  That could be as high as 44 percent in 2013.  Any income the child in question earns from employment will be taxed at the normal income tax rate for that child.

 

Minimizing the Tax

The central question for HNW families and their wealth advisors is:  How do you minimize or avoid altogether the so-called kiddie tax?

The Internal Revenue Service tends to be one of the organs of the federal government that’s very effective at its roles and responsibilities, and predictably, avoiding or minimizing the kiddie tax is indeed very difficult.  That said, there are a few strategies HNW families and their advisors may wish to consider:

·       Work within the numbers.  The first and simplest tactic is to make sure that the unearned income that each child receives doesn’t exceed $1,900.  Advise HNW families to do this by assiduously tracking the dollar value of assets given to their children each year and strictly limiting gifts to children to those assets that are non-interest bearing or dividend paying.  There are plenty of securities that don’t pay dividends and plenty of other asset classes.  These include raw land, which creates no income.  Using the example of non-income generating raw land, the underlying reasoning here is that any possible future appreciation may be taken in the form of lower taxed gains on the child’s return up to $2,000, while under the age limit.  After the age limit, the child can sell whatever he wants and pay at his own rate.

 

·       Create 529 savings accounts.  If the assets to be gifted are for future college expenses, consider the use of a 529 savings account.  In these accounts, all gains and income are tax-deferred and then tax-free, if used to pay for qualified educational expenses.  A further benefit of the 529 account is that the grantor can control the assets, leaving the child as the beneficiary, but not in control of the assets.  In short, there’s added reassurance that assets being gifted will be utilized strictly for the designated purposes.1

 

·       Purchase U.S. savings Bonds.  They may sound unexciting, but U. S. savings bonds may have a similar tax benefit.  The income tax on the interest from U. S. savings bonds can be deferred until the bonds are redeemed.  If the redemption occurs after the age threshold is reached, the bonds can be cashed in at the adult child’s own tax bracket.  Of course, currently there’s the issue of nearly non-existent interest rate returns.  One solution would be a tax-deferred annuity.  But that poses other problems, such as a penalty for withdrawals prior to age 59½.2

 

Trusts

Ultimately, all the wealth transfer tactics in the world can’t supersede the importance of being aware of the risk of having assets in a child’s name:  When that child reaches age 18 or 21, he’s free to do what he wants with the money.  Obviously, this may be too tempting for some children to pass up, and care should be taken to protect the assets from poor judgment and bad behavior.  Under these circumstances, HNW families should strongly consider the use of a trust with the parent or some other mature individual as the trustee.  That way, the parent controls the flow of the money and the associated tax consequences of any distributions to the child.

The type of trust to use would be one in which the grantor –grandpa or mom, for instance – controls the assets with the child as the beneficiary.  This allows the trustee to balance the intricate blend of trust assets.  The trustee will coordinate investment, spending, tax savings, and avoiding the kiddie tax will be a priority as needed throughout the life of the trust.

Blocking and tackling around taxes through transfers of assets between family generations can be an effective strategy.  But, as with all tax planning tactics that are geared around wealth management goals, it’s important to take a conservative approach and emphasize control and discipline in all that you do.

 

Endnotes

1. Prior to investing in a 529 plan, investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other benefits that are only available for investments in such state’s qualified tuition program.  Tax treatment at the state level may vary.

2. Annuities are long-term investment vehicles designed for retirement purposes.  Gains from tax-deferred investments are taxable as ordinary income upon withdrawal.  Guarantees are based on the claims paying ability of the issuing company. Surrender charges may apply.

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