Take these steps to avoid ‘kiddie tax’ exposure

Due to my kids’ investment income, they have been hit hard by the “kiddie tax.” How can we minimize its impact?

Many investors are familiar with the term “kiddie tax,” commonly used to describe an extra tax liability for a child’s investment earnings. Generally, income is taxed at the tax rate of the individual who receives it. For example, if you are in the 39.6% tax bracket, your top dollars are taxed at that 39.6% rate. If your child is in the 10% bracket, the child pays tax at a maximum rate of just 10%. However, it’s not that simple.

A special rule applies to certain children who receive unearned income above an annual threshold amount. The annual threshold is adjusted for inflation, but recent increases have been small or non-existent. For tax year 2014, the threshold is still $2,000, the same as it was last year. If a child receives more than $2,000 of investment income, the excess will be taxed at the top tax rate of the child’s parents. Thus, instead of being taxed at the 10% rate, your child may be taxed at the 39.6% rate on the excess above the threshold amount.

In addition, originally the kiddie tax only applied to children younger than age 14. This limit has been raised several times over the years, and currently the kiddie tax applies through age 18. For full-time students between the ages of 18 and 24, the tax applies if the child does not have earned income in excess of half of his or her annual support. In other words, if your dependent child is in college, the kiddie tax likely still applies.

It certainly makes sense to try to avoid kiddie tax exposure through effective tax planning strategies. The key is to keep your child’s unearned income below or near the $2,000 threshold. Examples include:

Utilize tax-deferred investments that don’t produce current income, such as growth stocks or growth stock mutual funds. You can give your child stocks, or funds made up of stocks, from companies that reinvest their profits for future growth rather than paying them to shareholders as taxable dividends. You could then wait until after the child is no longer subject to the kiddie tax to sell-the year he/she graduates from college or turns 24-and the profit will be taxed at the child’s capital gains rate. You could also look into buying index funds whose investments mirror a stock index or some other criteria and are likely to generate minimal taxable annual income. Tax-managed mutual funds are specifically designed to generate little taxable income. Again, you could sell them after the kiddie tax stops being applicable.

If your child is currently almost at the age when he/she will not be subject to the kiddie tax, consider buying a Treasury bill or U.S. savings bonds that won’t mature until the no-kiddie-tax year. That way, the child won’t earn any interest while the kiddie tax still applies.

Allocate a portion of your child’s investment portfolio to municipal bonds or municipal bond mutual funds. Generally, the income received from these investments is completely free of federal income tax, thus avoiding the kiddie tax threshold.

Hire your child to work in your practice. Since wages constitute earned income, the earnings will not trigger the kiddie tax. As long as the child is paid a reasonable salary for the services performed, your practice can also deduct the wages. In addition, this is a great way to help a child save money for college.

How do I make sure that my socially responsible fund isn’t investing in companies I don't want to own?

Socially responsible funds typically will not invest in corporations that manufacture weapons, tobacco products, or alcohol. One of the problems managers of socially responsible mutual funds face is determining all of the types of business in which a conglomerate may be involved. It is important to read the fine print of the prospectus to determine the latitude the fund gives itself when selecting particular companies. The fund’s prospectus will spell out the exact industries that may or may not be excluded from consideration. The fund’s quarterly and annual reports are also good sources of information and will list the specific fund investments.UT

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