If your teen or adult child in college has been dabbling in stocks or cryptocurrency, their gains may trigger a surprise bill at tax time.
That’s because of the so-called “kiddie tax,” an extra levy for parents once their child’s investment income — capital gains, dividends and interest — exceeds a certain threshold.
“It combats the ability to shift brokerage accounts to your kids,” said Dan Herron, a San Luis Obispo, California-based certified financial planner and CPA with Elemental Wealth Advisors.
Previously, higher-income parents moved assets to their children’s accounts to pay lower taxes on earnings. However, the IRS added kiddie tax to crack down on this practice.
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Kiddie tax may apply to children under age 18, or under age 24 if they’re full-time students, meaning parents with college kids may still be affected.
Here’s how it works: Let’s say a 22-year-old college student made $5,000 from investing. While the first $1,100 is tax-free, the student will owe levies on the next $1,100 at their rate.
“Beyond that, gains get taxed at the parents’ rate,” said Olga Espiritu, a CFP and president of Tree Of Life Wealth Advisory Group in Cooper City, Florida.
Any profit above $2,200 is subject to kiddie tax, charged to the parents at their rate, assuming the student is full-time and a dependent on their tax return.
In this case, the parents would pay levies on $2,800, which is $5,000 minus the $2,200.
The deadline for brokerages to send Form 1099-B, covering each account’s gains and losses for 2021, was Feb. 15, so parents may soon find out if this is an issue.
If you owe kiddie tax for 2021, there are limited ways to reduce your bill before the tax deadline. However, there are plenty of options for avoiding these levies in the future, experts say.
“I think you need to use the 2021 tax year as a learning experience,” Herron said. “Especially if there were some unintended consequences.”
For example, you may encourage your teens or adult children in college to invest in a Roth individual retirement account, assuming they have “earned income,” or funds from a part-time job, Espiritu said.
“They could still access any contributions penalty and tax-free,” she said. “And if they don’t need it right away, they can start saving for retirement a lot earlier than their peers.”
However, without earned income, they may avoid trouble by holding certain investments long-term in taxable accounts, Herron suggested.
For example, exchange-traded funds may be more tax-efficient than assets with dividends or capital gains payouts.
“If you’re going to open a brokerage account for your kid, talk to your accountant,” Herron added. “You need to fully understand exactly what you’re getting into.”