The new federal tax law made changes to the so-called "kiddie tax" that could impact how some advisers handle their clients' financial plans.
While experts say lawmakers largely simplified the kiddie tax, the changes may change how some clients finance a child's college education and, in rare circumstances, cause some low- to middle-income families to pay more in tax.
"This is a big deal," said Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center. "I think it creates all sorts of traps for the unwary."
The kiddie tax is a tax on a child's net unearned income — essentially, income excluding wages and business income. It primarily affects income from investment assets — such as interest and dividends from mutual funds, or capital gains from the sale of a stock — but could also affect things like income from inherited retirement plans, experts said.
The tax is meant to prevent parents and grandparents in high-income tax brackets from shifting investment assets to their children and therefore get a lower tax rate. It affects children under age 19, and full-time students under 24.
More than 215,000 tax returns were subject to the kiddie tax in 2011, generating $621.2 million in revenue for the federal government, according to the most recently available analysis from the Internal Revenue Service.
Under prior kiddie-tax rules, a child's unearned income exceeding $2,100 was taxed at the parents' marginal rate for income and capital gains. However, under new rules that unearned income is taxed at the rates for trusts and estates.
On its face, that may appear to be a big change from a tax-liability perspective, since the rates for trusts and estates increase much more quickly than those applying to income and capital gains.
In 2018, for example, a married couple pays the top 37% marginal income tax rate when their taxable income exceeds $600,000. However, for estate and trusts, the top 37% rate kicks in when income exceeds $12,500 — a much lower threshold.
In practice, though, most taxpayers — especially the children of affluent parents — will likely end up paying less tax as a result, experts said.
Take this example, provided by Tim Steffen, the director of advanced planning in Robert W. Baird & Co.'s private wealth management group. Let's say a child subject to the kiddie tax is the beneficiary of a grandparent's IRA, and takes a $10,000 distribution from the account. Assume the child's parents are subject to a 35% marginal tax rate.
Under prior rules, the child's total tax liability would be $2,870. However, under the new law, that same child's liability is $1,644 — in other words, $1,226 less.
Here's another example, this time for a stock sale generating a $20,000 capital gain to the child. The parents' taxable income is such that they are subject to a capital gains rate of 15%.
The child's tax liability under former rules would have been $2,685; new rules provide a $2,555 liability – a $130 savings, Mr. Steffen said.
"For parents at the higher brackets, this change may actually benefit the kids," Mr. Steffen said. For parents at lower brackets, this change may end up costing the kids more because the child may find themselves at a higher tax rate than their parents are actually in." (The higher rate here refers to the trust and estate tax rate.)
That latter scenario — whereby a child would pay more — is "really at the margin" instead of the norm, said Beth Shapiro Kaufman, president of Caplin & Drysdale.
"That will be a pretty unusual situation, where a kid with substantial unearned income has parents in a lower tax bracket," she said.
Overall, Ms. Kaufman thinks the new rules simplify the tax calculation for many families. Now, the same kiddie-tax rates apply to all children, instead of having varying rates based on parents' income.
Mr. Steffen said $23,000 in capital gains is the rough tipping point for tax liabilities in 2018.
"For a child with capital gains this year of under $23,000, they'd probably pay the same or less tax this year than under the old rules, assuming the parent is at a 15% capital gains rate, which is where most people are," he said.
Financial advisers need to be careful about realizing large gains in children's accounts, Mr. Steffen said.
A grandparent, for example, may gift assets to a child early on, which may have subsequently grown a lot in value if held until later teenage years. Kids may sell such portfolio assets to help finance college costs, but advisers should consider having them starting the sell-down sooner to help manage gains — and reduce the kiddie tax.
Mr. Rosenthal of the Tax Policy Center said it could put pressure on parents to use 529 plans as much as possible.