Taxes & Custodial Brokerage Accounts (Including the Kiddie Tax)
An often-ignored topic when it comes to custodial brokerage accounts and minors is the taxes that may be owned by a child who is the beneficiary of a custodial account. This article provides some clarity on taxes associated with such accounts and the issues that may be faced by parents or guardians who typically set up the accounts for their kids.
I am not a financial advisor so it is probably best to consult one or a tax attorney to give you advice on taxes related to custodial accounts.
A custodial account is a type of account typically set up by a parent or guardian for the benefit of a child who is considered a minor. This account can be set up with a bank, brokerage firm, or mutual fund company for a minor. The parent/guardian that has custody over a child controls the account until the child is 18-25 years old. For more details on Custodial accounts please go here.
Definition of Investment Income and Earned Income
Before we explain the taxing of money in custodial accounts, you first have to understand the difference between investment income and earned income as defined by the Internal Revenue Service (IRS).
The IRS defines investment income (also known as unearned income) as the combination of interest, dividends, and capital gains.
Investment income should not be confused with earned income, which is income derived from salaries, wages, taxable scholarships, and grants.
The tax rules relating to custodial accounts hinges upon if your child receives:
Only investment income
Only earned income, and
Both investment income and earned income.
For a full description by the IRS of the circumstances under which your child must pay taxes, please see the following publication on the website of the IRS: Publication 929.
If Your Child Receives Only Investment Income
In most instances, your child, as a single dependent, will not be required to file or pay taxes on the first $1,100 of his investment income. However, once his investment income exceeds $1,110 he must file a tax return, or, as discussed below, you may choose to include his investment income on your own tax return.
This investment income will be reported on his own tax return, and the amount owed will be calculated on the following IRS form which is to be attached to his return: Form 8615.
You Can Report Your Child’s Investment Income on Your Taxes
You can elect to include the investment income of a child (who is under 19 years of age or under age 24 if he is a full-time student) on your tax return. You can only do this if your child’s investment income is more than $1,100 and less than $12,400.
If you elect to report this income on your own tax return, your child won’t have to file a separate return.
A parent’s tax return that includes the investment income of children must be accompanied by the following IRS form: Form 8814.
Unlikely Your Child Will Make Enough Investment Income To Be Taxed
The truth is that it is very unlikely that your Teeevestor will make more than $1,100 in investment income because that would take a lot of investments to make such profits in any assets like stocks and bonds. In addition, this type of income is generally recognized when stocks and other assets are actually sold. So, if your child invests in stocks through a custodial brokerage account, no investment income is recognized, until the stocks are sold. Sure, he may get dividends on stocks, but that will most likely be a tiny amount of money.
If Your Child Receives Only Earned Income
Your child has to file a tax return if he receives only earned income and if that income is more $12,400. Some tax experts recommend that he files a tax return anyway if he makes less than this amount since he may be able to get money back if too much tax has been withheld.
If Your Child Receives Both Earned and Unearned Income
Gross income is used to determine whether your child has to file a tax return when he has both investment income and earned income. Gross income, also known as “before-tax” income, is loosely defined as the total of earned income and investment income before any deductions for taxes are taken.
Tax returns are required to be filed if your child’s gross income for the year exceeds the greater of a) $1,100 or b) his earned income plus $350, up to a total of $12,400. Once your child’s earned income (typically, wages from employment) exceeds $12,400, a tax return must be filed regardless of whether he has any investment income. In addition, if your child does not have any investment income and is self-employed – that is, if he is an entrepreneur – he will have to file a tax return if his net profit exceeds $400.
Your Child’s Likely Tax Bracket (Includes the Kiddie Tax)
Obviously, understanding when your child is required to file a tax return is just one piece of the puzzle. It is also important to understand how to figure the tax rate that will be applied to his investment income.
As discussed earlier, your child is required to pay taxes on investment income exceeding $1,100.
Assuming he is under 19, any investment income he makes over $1,100 and put to $2,200 will be taxed at his tax rate which is most likely around 10%.
Any investment income he makes over $2,200 is subject to the kiddie tax, which is in most cases, your tax rate as the parent.
The kiddie tax is meant to prevent parents (or other adults) from establishing custodial accounts for their children, seeding it with investments, and paying investment income taxes at their childern’s tax rate (which is probably about 10%). The IRS put a stop to such practices by imposing a high tax rate if children appear to be making a lot of money in investment income.
Filing Tax Forms for Excessive Gifts
As we described in our article on custodial accounts, you can individually contribute up to $15,000 annually to your child’s custodial account without triggering any gift taxes. If you are contributing jointly with your spouse, you can give your child up to $30,000 annually through a custodial account established in his name. If your contributions are higher than these thresholds, you will have to file a tax form to disclose the gifts to the IRS.
Filing the forms is extremely unlikely to result in getting taxed because the lifetime cap on how much money you can give to a child (or any individual for that matter) is in the millions of dollars. But the filing of the taxes is just one more nuisance you probably wouldn’t want to deal with.