The Kiddie Tax is a small, yet powerful, part of the tax code that all investors should consider taking advantage of. The Kiddie Tax says that a minor can realize up to $1,300 in capital gains with no tax or reporting requirements. For example, if your child has a custodial brokerage account with $1,000 in it, and the value grows to $2,000, you could take profits in that account tax-free. Not only is this valuable for the child, but the Kiddie Tax presents adults with tax minimization strategies as well.
Shifting capital gains to children
An adult parent who has capital gains should consider taking advantage of the Kiddie Tax. Here’s an example of how it can be done:
John Doe has two children, a 4 year old and a 6 year old. John invested $25,000 in stock ABC many years ago and it is now worth $50,000. John has an unrealized capital gain of $25,000. At a 15% long-term capital gains rate, John would pay $3,750 in taxes if he sold the stock today.
John can gift $2,500 worth of the stock to each child for a total gift of $5,000. This gift would transfer $2,500 worth of capital gains to his children ($1,250 each).
Once inside of the children’s accounts, John can sell the stock for them. The Kiddie Tax will allow each child’s $1,250 gain to be realized tax-free and unreported.
John, meanwhile, just made $2,500 of his taxable gain disappear. This maneuver equates to $375 in tax savings for John.
All else being equal, if John does this for 10 years, he can gift a total of $25,000 to each child and totally eliminate any tax liability associated with the original $25,000 worth of gains on his investment.
What type of gains should you transfer?
Any adult who has gains and someone they can gift stock to, who would qualify for the Kiddie Tax, should consider this strategy. This is especially true for an adult who has short-term capital gains that they can transfer to a minor. Because short-term capital gains are taxed at higher rates, the tax savings can be greater.
Another candidate for transfer is an adult who has gains in company stock, either from an ESPP or stock award. Keep in mind though, ESPP shares cannot be transferred unless you are two years past the grant date and one year past the purchase date.
Stock awards, like RSUs, are generally transferrable as soon as they vest. However, because the cost basis is usually set to the day of the vest date, you may not have any gains that the Kiddie Tax would allow you to take advantage of. But, if you are sitting on company stock from a stock award in the past, and you do have gains, that is a perfect case for gifting that stock.
And it’s not just parents who should consider this strategy. Grandparents who have sizable portfolios should be looking to make gifts of this nature as well.
Key considerations
If you are going to make a gift for the purpose of taking advantage of the Kiddie Tax make sure you take the following items into consideration.
First, the Kiddie Tax limit for 2024 is $1,300 on unearned income. That includes capital gains AND dividends and interest. If your child has existing investments then you need to be sure to check if they are earning dividends and interest. If they earn $100 in dividends and interest in 2024, then the amount of capital gains they can realize while staying under the Kiddie Tax is $1,200, not $1,300.
If you go over the $1,300 threshold you will likely be required to file a tax return for your child. For simplicity sake, we strongly recommend staying under the $1,300 threshold. In our own management, we try to stay under $1,200 just to be safe.
Second, we recommend executing the strategy outlined above in one full swoop. Meaning, the process of gifting the stock to the minor and then selling it for the minor should be done as close together as possible. Doing so will ensure that the realized gain is what you expected when you first implemented the plan.
If you gift stock to a minor and then forget to sell it, the stock may appreciate over what you can sell it for while staying under the $1,300 Kiddie Tax threshold. So if you are gifting stock and then have no control over it being sold, make sure there is strong communication between the giftor and the giftee’s adult. An example is an uncle gifting to a nephew, or a grandparent to a grand child.
Thirdly, after selling the stock we encourage you to reinvest the proceeds in a broad market ETF for the minor’s benefit. A low cost ETF like SCHB will ensure that the child’s portfolio grows with the market.
Lastly, be sure to keep good records of all of gifts and subsequent stock sales. Just because there is no tax reporting requirement if you stay under gifting limits and Kiddie Tax thresholds, doesn’t mean you should forego sound record keeping.
Be sure to reach out to us to talk tax minimization strategies like the Kiddie Tax and how we can use it for your benefit!
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