7 Ways to Avoid Paying the Dreaded Kiddie Tax

Ross Quade | General | 7 Apr, 2016 | No Comments

Were you surprised by the fact that your nearly adult child was asked to pay a Kiddie Tax? You are not the only one. The rules on this tax extend from small children all the way to students who are less than 24 years old. To prevent parents from placing their investments under their children’s names to pay a lower tax rate, Congress created the “Kiddie Tax”. Under these laws, if a child receives more than $1,900 in investment income, it will be taxed at their parent’s tax rate instead of the child’s. The good news is that the Kiddie Tax should not catch you off guard, as there are legal means of avoiding paying it. Let’s take a look at seven legal ways that you or your child can avoid paying the dreaded Kiddie Tax.


1.  Municipal Bonds

One way to avoid the Kiddie Tax is to purchase a municipal bond for your child that will reach maturity when he or she is older and no longer falls under the Kiddie Tax category. You will not have to pay federal tax on the interest earned on the bond when your children are at a younger age and still subject to the Kiddie Tax since these types of bonds are exempt from paying federal income tax. In the end, if you sell the municipal bond for profit, it will be taxed as a capital gain under your child’s capital gains tax rate, as long as you wait to sell it until your child no longer falls under the Kiddie Tax category.


2.  Fund a College Savings Plan

You can shelter funds by putting them into a college savings plan like the ESAs and 529. These are both state-sponsored investment accounts that will give you tax-differed earnings. Additionally, you do not have to pay taxes to withdraw funds to pay for secondary school or higher educational expenses as long as the costs qualify.


3.  Put Half of Income into a Trust

Trusts are separate tax entities. They pay tax on income that is placed into the trust and not under your child’s name. Once you put $2,450 into a trust as taxable income, it will be taxed at a 10 to 15 percent rate up to $4,250, which allows you to give your child $2,000 in income and put $2,450 in the trust. Keep in mind that splitting funds with a trust is a viable option that is worth your consideration. However, many parents choose not to do it due to the initial costs of creating a trust, as well as the annual expenses associated with filing for trust returns.


4. Consider Permanent Life Insurance 

An excellent option for avoiding the Kiddie Tax is to take out a permanent life insurance policy. This will allow you to tuck away funds into the cash-value section of the policy. These funds will be tax deferred until you choose to borrow them or withdraw them. The rates of return for a 15 to 20-year period of a permanent life insurance policy can be substantially higher than other safe money investment equivalents such as money markets or CDs, and you will not have to pay current taxes on it.


5.  Consider Growth Mutual Funds or Stocks

You can gift your child funds made of stocks or stocks from those companies that invest their profits for future growth instead of paying shareholders as a taxable dividend. If you choose this option, then you must wait until your child does not fall under the Kiddie Tax category to sell the stocks (i.e., When he or she turns 24 or graduates or drops out of college). At this time, the profits made from the stock will be taxed at the child’s capital gain rates.


6.  Make Your Company Family-Run 

You can avoid the Kiddie Tax by making your small business a family affair and hiring your child. Paying your child a salary will not fall under the umbrella of unearned income and so will not result in him or her having to pay the Kiddie Tax. If you go with this strategy, then it is essential that you pay a reasonable salary for the services that he or she performs and not an outrageously high amount. If you do keep it reasonable, then your business can deduct your child’s wages on your own taxes. This is an excellent option for aiding your child, or children in saving money for higher education without having to deal with adverse tax consequences.


7.  Purchase a Treasury Bill

If your child is close to being at the age when he or she does not have to pay the Kiddie Tax, then buying a Treasury bill may be the ideal solution. To do this, purchase a bill that won’t mature until after your child does not fall under the Kiddie Tax category, which will ensure that he or she does not earn interest on the bill while they still are subject to the Kiddie Tax.


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