Last month, we introduced the case for custodial accounts with the Kiddie Tax being a key component of our argument. The Kiddie Tax says that a child’s first $1,100 in unearned income is not taxed. The next $1,100 is taxed at the child’s marginal tax rate. Anything above $2,200 is taxed at the parent’s marginal tax rate. So if your child does not have any income, the first $2,200 in unearned income is tax-free. Understanding how to use the Kiddie Tax to your advantage can go a long way in boosting your child’s after tax return for when they start using the money.
Let’s take a hypothetical custodial account that a parent set up for their 5 year-old child with a starting balance of $10,000 in 2010. The account was invested 100% in stocks and earned an annualized return of 12% (after inflation). This $10,000 account grew to $34,987 by the end of 2020. If a simple buy and hold strategy was employed, there is a $24,987 unrealized gain in the account. However, if a tax-efficient strategy was employed, we could have taken the unrealized gain down to $7,300, without reducing the overall value of the account (i.e. it would still be worth $34,987).
The table below shows how we could have achieved this by taking up to $2,200 in profits each year when applicable and raising the cost basis of the account:
|YEAR||S&P 500 RETURN||PROFIT||PROFITS LEFTOVER||BALANCE (EOY)||COST BASIS (EOY)|
Starting in 2010, for instance, the full $1,314 profit could have been realized and reinvested back into the market. This locks in a tax free gain of $1,314 since it is under the $2,200 Kiddie Tax limit, and raises the cost basis for 2011 to $11,314. The first year where there is more than $2,200 in profits is 2013, when the S&P 500 rose 30.50. In that year the parent could still take $2,200 in profit and reinvest those proceeds. This would have raised the cost basis to $14,976 and left $1,697 in unrealized gains in the account (profits leftover).
In 2014, $2,157 worth of new profits were generated, all of which could have been realized tax-free since they are below the $2,200 threshold. Then, in 2015, when the market was flat, the left over profit of $1,697 (from 2013) could have then been realized and reinvested. All in all, if this process was repeated over the 10 year period, the account could have had a new cost basis of $27,663 and a value of $34,986 for an unrealized profit of $7,323 at the of 2020. This compares to the buy and hold account which would have an unrealized profit of more than $24,000. Remember, both of these accounts are worth nearly $35,000 off of an initial $10,000 investment. So in terms of tax treatment, it’s obviously better to have $7,300 worth of unrealized gains versus of $24,000.
Things to consider
If you want to take advantage of the Kiddie Tax in your child’s custodial account, be sure to follow a few guidelines:
- Select the correct lots: you’ll want to make sure you’re selling the exact lot specified, which may be different from FIFO or LIFO settings. If not done correctly you could end up with a situation where you’re not taking the profits you think you are.
- Stay under the $2,200! If you go over $2,200 in realized gains in a given year then the gains will be taxed at the parent’s marginal tax rate. If you’re a high earner that could be a big waste of money.
- Don’t worry about wash sales: wash sales only apply to taking losses. Because we are taking profits there is no wash sale rule when you sell something and buy it right back immediately.
- If your child works and earns income you’ll need to do further reading on the Kiddie Tax as the rules change depending on their income. If they have zero income you can take the $2,200 hassle free.
- You can apply this same practice to any individual stock as well (TSLA, AAPL, etc) and end up with similar benefits!
With knowledge on your side, you can use the Kiddie Tax to your advantage and give the after-tax performance of your child’s custodial account a major boost!