Please note the information below is intended to provide generalized information that is appropriate in certain situations.  It is not intended or written to be used, and it cannot be used by the receipient, for the purpose of avoiding federal tax penalties that may be imposed on any taxpayer.  The contents of the information provided below should not be acted upon without specific professional guidance.  Please call us if you have any questions.

Years ago, it was often possible to save taxes by investing in a college-bound child’s name rather than in the parent’s name to take advantage of the child’s lower federal income tax rates (that is, the rates for a single unmarried person). This strategy is called “splitting income with the child.”

The concept of splitting income is simple. The client makes gifts to the college-bound child. Under the $15,000 annual gift tax exclusion (for 2018), a married couple can jointly give up to $30,000 per year to the child without paying any federal gift tax, without diminishing the $11.18 million (for 2018) unified federal gift and estate tax exemption allowed to each spouse. Investments are then made in the child’s name, and the resulting income and gains are split off from the parents’ return and hopefully taxed at the child’s lower rates. The college fund then compounds that much quicker, because the after-tax rate of return is that much higher. However, watch out for the Kiddie Tax rules. 

Under the Kiddie Tax rules for 2018–2025, part of a dependent child’s unearned income (typically from investments) can be taxed at the federal income tax rates that apply to trusts and estates, which can be as high as 37 percent, or 20 percent for long-term capital gains and qualified dividends, instead of at the child’s lower rates (that is, the rates that would otherwise apply to an unmarried taxpayer with a modest amount of income), which can be as low as 10 percent, or 0 percent for long-term gains and dividends. When the Kiddie Tax is applied, it will at least partially defeat the tax-saving purpose behind family income-splitting. That was the intent on the legislation. However, the tax can be minimized or maybe even completely avoided with careful planning.