Changes to tax laws have made it more difficult for parents who gift stocks and other securities to avoid a higher tax bite today, as well as when the time comes to plan their estate.
Until 2005, the “kiddie tax,” a tax on a child’s unearned income over a certain amount (such as dividends and other capital gains) was paid at the parents’ marginal rate if the child was under age 14. After that, the child was taxed as an unmarried adult who, presumably, fell into one of the lowest two tax brackets. In 2006, the age limit was raised to 18 years old. And starting in tax year 2008, the age limit will apply to children under age 19 — or to “kiddies” who are full-time students under the age of 24.
The ability to gift appreciated stock to children who would pay a lower tax rate was an attractive loophole for parents, especially since taxes on capital gains in the lowest tax brackets have been as low as 5 percent, compared to the 15 percent their parents would pay, says Naomi Ganoe, a tax manager for CBIZ in Akron. What’s more, taxes on capital gains in those lower brackets will fall to zero for 2008 through 2010, while the 15 percent tax rate for higher brackets remains the same through the end of 2010.
But under the new “kiddie tax” rules, teens under 19 or who are full-time students will have to pay tax on their unearned income at their parents’ rate of 15 percent starting in 2008. The closing of this loophole has frustrated many parents who used it to fund college tuition expenses.
“Many of our clients picked or inherited stocks years ago with the intention to gift them to their kids and pay for college and this throws a curveball in their planning,” says Brian Dean, executive vice president of CBIZ Financial Solutions in Cleveland.
For families with a child 18 or over, Dean advises selling those stocks now while the child is subject to the 5 percent tax, rather than wait until next year when the parents’ higher rate would apply. “You have between now and the end of the year to gift and sell the stock,” he says.
Another money-saving option advises the child to hold onto the gifted stock until the first year after graduation — before they earn a salary. Then, he or she can sell the stocks at his or her own lower tax rate.
Families also might want to look at other investments that are tax friendly but not associated with the “kiddie tax,” such as a 529 college savings plan. The plans are sponsored by states, state agencies or educational institutions and give tax advantages to encourage saving for future higher-education expenses. As long as the money is used for qualified college expenses, withdrawals from 529 plans are tax free. Otherwise, withdrawals from the plan are taxed as ordinary income and subject to a penalty.
“529s can be a great tool for anyone — there are no income limitations or age restrictions. And it allows parents to invest in their child’s and even their grandchildren’s college funds,” says Ganoe. In fact, Federal law allows you to give up to $12,000 a year, per beneficiary, without triggering gift taxes.