Did you know there are easy ways you can lower your tax bill each year while also setting your children (or grandchildren) up for financial success? We’ve previously written about taking advantage of the kiddie tax, but today we’re going to expand that conversation. We’ll look at a real example we’ve implemented for clients this year and quantify the tax savings these steps can have over an 18 year period.
Taking advantage of the kiddie tax
The Kiddie Tax is a provision in the tax code that, in part, allows a minor to pay zero capital gains taxes on the first $1,350 of capital gains in 2025 (the limit adjusts with inflation each year). To visualize the benefit of this Kiddie Tax provision, let’s imagine a child who realizes $1,350 of gains in a custodial brokerage account each of the next 18 years. In comparison, the adult parent does the same, but pays a 20% long-term capital gains on the $1,350. Here is the difference in tax treatment over 18 years:
The result is a tax savings of nearly $5,000 for the child compared to the parent. The best part is these gains can be taken without the child needing to file a tax return. Once you pass the first $1,350 of income for a child (earned or unearned), a tax return will need to be filed. So if you don’t want to file a tax return, be sure to stay under this $1,350 limit.
If you don’t mind filing a tax return, the Kiddie Tax provision says that the “next $1,350” of earned or income is taxed at the child’s rate. Because most young children have no income, their tax rate on long-term capital gains would likely be 0%. Therefore, they could potentially pay zero tax on $2,700 worth of capital gains each year. This would double the tax savings over 18 years in our example above from $4,860 to $9,720.
If you were to implement full Kiddie Tax savings with two kids for 18 years the tax savings would likely eclipse $20,000 after accounting for inflation adjustments.
How can you execute this to save taxes?
So how can you actually execute this idea to get the most out of the tax savings? One of the best strategies involves gifting appreciated stock or ETF holdings from a parent to a child. For example, let’s consider a parent with $750,000 in a taxable brokerage account, consisting of $550,000 in basis and $200,000 of long-term capital gains.
For simplicity sake, we will assume the brokerage account holds one balanced market ETF that contains all of the embedded gains. To take advantage of the first $1,350 Kiddie Tax threshold, the parent would gift $5,063 per kid (consisting of $3,713 basis and $1,350 of gains). With two kids, the parent will gift a total of $10,126. The parent will save about $540 in taxes by shifting assets from their own 20% bracket to their children’s 0% bracket.
If the parent doesn’t mind filing a tax return for their children, they can double the amount of their personal tax savings to $1,080.
Important step!
To make sure you take proper advantage of the Kiddie Tax provision, you must sell the assets as soon as they are transferred to the child’s brokerage account. This will realize the $1,350 gain inside the child’s account, and then the entire principal can be reinvested. This is very important because it will immediately turn the gain into new principal once it is inside of the child’s account. Using our example above, the child’s basis on their new investment goes to $5,063 (since the gain is realized and reinvested, but not taxed).
The concept of absorbing gains into the child’s new principal will have a huge impact on the tax treatment of the portfolio years down the line. Consider the comparison below, where we execute the gifting strategy outlined above over 10 years (assuming 7% annualized return):
The total value of the portfolios is the same, but the cost basis and embedded capital gains vary significantly depending on if you absorb the gains right away inside the child’s account.
If you don’t take advantage of the Kiddie Tax provision each year to absorb the gains, your child will have more capital gains after 18 years ($33,458 vs $19,958). This could cost them thousands of dollars in future tax liability.
I don’t want my 18 year old to have $75,000
We understand that, tax savings or not, not every parent thinks it’s a good idea for their kids up to have access to thousands of dollars on their 18th or 21st birthday (the ages at which minors can take over a custodial account). With that in mind, there is an additional step parents can take after executing our example. This step will give the parent more control and increase tax efficiency even further: reroute the funds into a tax-advantaged 529 plan.
Moving the funds into a 529 plan accomplishes three main goals:
- Takes advantage of initial Kiddie Tax savings
- Locks the funds in a more restrictive account so the child can’t access them easily at age 18 or 21 (other than for qualified education expenses)
- Expands the tax advantages to tax-deferred growth & possible up front tax savings at the state level)
Let’s go back to our initial example of the parent gifting to two kids from their $750,000 portfolio. Now, let’s assume that after the gift is made and Kiddie Tax savings are realized, the funds are then deposited into a 529 plan. If the family lives in a state that allows deductions for 529 plan contributions, like Illinois or New York, the parent could save $500-$1,000 on state taxes. These savings on state taxes add to the savings realized at the federal level from the tax avoidance on capital gains.
Do this for 18 years with 529 plan contributions each year, and the total tax savings are likely to approach $30,000-$40,000 (based on two kids). Moreover, the embedded capital gains will fully disappear from the child’s cost basis since the funds are now inside a tax-advantaged 529 plan.
One note on this aspect of our plan: 529 plan contributions are most advantageous for parents who live in high tax states and whose states allow 529 plan contributions to be deducted. Click here for a list of 529 plan deductions by state.
If you don’t move the money into a 529 plan, you can still spend it down. Money inside a child’s brokerage account can easily be spent on sports, school, vacations, a teenager’s credit card, car payment, etc. Assets inside a custodial account must simply be spent “for the benefit of the child” — the language of which is broad and open to interpretation.
Being proactive with tax planning
The Kiddie Tax is intentionally set at a low threshold so that parents can’t skirt the system out of hundreds of thousands of dollars in taxes. However, with a little planning and sound execution, parents can use the Kiddie Tax to save thousands of dollars over 5-10-20 years. At the same time, you can set your child (or grandchild) up for financial success. Taking advantage of the Kiddie Tax would fall into the “low hanging fruit” tax planning category: its easy to execute and you can do it on your own (or discuss with your advisor). We are executing this strategy for clients all year round, so reach out to us if you are interested in discussing further.
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