The 2017 Tax Act makes a number of changes that may be significant for taxpayers who support children or other dependents. The questions below explore the effects of the new act in five such areas.

1. How does tax reform impact the treatment of unearned income of minors, or the so-called “kiddie tax”? 

Under prior law, children under the age of nineteen (age twenty-four for students) were required to pay tax on their unearned income above a certain amount at their parents’ marginal rate. The so-called “kiddie tax” applies to children who have not attained certain ages before the close of the taxable year, who have at least one parent alive at the close of the taxable year, and who have over $2,100 (in 2015-2018) of unearned income.

The kiddie tax applies to:

  • a child under age eighteen; or
  • a child who has attained the age of eighteen if (i) the child has not attained the age of nineteen (twenty-four in the case of a full-time student) before the close of the taxable year; and (ii) the earned income of the child does not exceed one-half of the amount of the child’s support for the year.

The tax applies only to “net unearned income.” “Net unearned income” is defined as adjusted gross income that is not attributable to earned income, and that exceeds (1) the $1,050 standard deduction for a dependent child in 2018, plus (2) the greater of $1,050 or (if the child itemizes) the amount of allowable itemized deductions that are directly connected with the production of his unearned income.

The 2017 Tax Act aims to simplify the treatment of unearned income of minors by applying the tax rates that apply to trusts and estates to this income. Therefore, earned income of minors will be taxed according to the individual income tax rates prescribed for single filers, and unearned income of minors will be taxed according to the applicable tax bracket that would apply if the income was that of a trust or estate (for both income that is subject to ordinary income tax rates and in determining the capital gains rate that will apply if long-term capital gains treatment is appropriate).

The rates that will apply to trusts and estates under the 2017 Tax Act are as follows:

Tax Rate

Trusts and Estate Income

10%

$0 to $2,550

$255 plus 24% of the excess over $2,550

$2,550-$9,150

$1,839 plus 35% of the excess over $9,150

$9,150-$12,500

$3,011.50 plus 37% of the excess over $12,500

Over $12,500

 This provision does not apply to tax years beginning after December 31, 2025.

Planning Point: Because the unearned income of minors was previously taxed at a parent’s tax rate, this means that a child with a relatively small level of unearned income may pay less on this income (a child can essentially have up to $4,650 in unearned income before he or she moves out of the lowest 10% tax bracket–$2,100 that is exempt and $2,550 taxed at the 10% rate). 

However, the minor will also jump into the highest tax bracket more quickly under the new law. While the minor’s parents will not be taxed at the 37% rate until their combined income for the year exceeds $600,000 (assuming a joint return), the child will be taxed at that rate once he or she has unearned income in excess of only $12,500. As a result, some parents may wish to consider taking steps to reduce the child’s taxable income (i.e., by keeping any funds invested until the child is no longer subject to the kiddie tax rules).

2. Does tax reform impact any personal tax credits other than the child tax credit?

Most of the personal tax credits were not impacted by tax reform. This includes the credit for the elderly and permanently disabled, adoption credit, the American Opportunity tax credit, Lifetime Learning tax credit, and the saver’s credit

3. How does tax reform impact the treatment of alimony payments? 

The 2017 Tax Act eliminated the previously existing above-the-line deduction for alimony for tax years beginning after 2018, and provides that alimony and separate maintenance payments are no longer included in the income of the recipient.

This provision is effective after December 31, 2018, but also applies to divorce or separation agreements executed before that date that are subsequently modified and specify that the new provision will apply.

Planning Point: This new rule means that alimony payments will no longer be considered compensation for purposes of IRA contributions, which could impact an alimony recipient’s ability to contribute to an IRA absent further guidance to the contrary. 

Under prior law, a taxpayer in a higher income tax bracket was essentially able to shift income to his or her former spouse (presumably in a lower tax bracket) through alimony payments. Certain specific requirements must be satisfied in order for a payment to be treated as alimony both under former and new law:

(1)   the payment is made in cash;

(2)   the divorce or separation instrument does not designate the payment as not includable or deductible as alimony;

(3)   there is no liability to make the payments after the death of the recipient; and

(4)   if the individuals are legally separated under a decree of divorce or separate maintenance, the spouses are not members of the same household at the time the payment is made.

Planning Point: The new treatment of alimony payments does not impact payments made to a former spouse for the support of a dependent. Further, when a parent remarries, support received from that parent’s spouse is treated as though it is received from the parent.

4. How does tax reform impact Section 529 plans? 

Under the 2017 Tax Act, Section 529 plans would be expanded to include the use of up to $10,000 per year for elementary or secondary school expenses (a provision that would have permitted Section 529 plan funds to be used for expenses incurred in connection with homeschooling was eliminated at the last minute).

Planning Point: This means that some clients may wish to open a second Section 529 plan in order to plan for K-12 school expenses. However, the $10,000 amount applies on a per-student basis (rather than a per-Section 529 account basis), meaning that if the student is beneficiary of several accounts, he or she can only receive a maximum of $10,000 from all accounts (amounts above the $10,000 will be taxable).

Further, the new law will permit Section 529 plan funds to be rolled over into an ABLE account for the designated beneficiary or the designated beneficiary’s family member in an amount up to the annual 529 plan contribution limit (rollovers would offset other contributions made to the ABLE account for the year). Amounts rolled over in excess of the limitation are included in the distributee’s gross income. These rules are effective for rollovers that occur after December 31, 2017 and before December 31, 2025.

5. How does tax reform impact ABLE accounts? 

The 2017 Tax Act expanded the ABLE account contribution rules so that the account beneficiary is now able to contribute his or her earned income even if the contribution (when added to other contributions) causes contribution levels that exceed the annual contribution limit. The account beneficiary’s contribution is limited to the lesser of his or her income or the federal single-person poverty limit. However, this additional contribution limit is unavailable to account beneficiaries who also contributed to a 401(k), 403(b) or 457(b) plan.

If the ABLE account beneficiary contributes to the account, he or she will be eligible for the saver’s credit. These provisions apply for tax years beginning after December 31, 2017 and before January 1, 2026.

Further, the Act will permit Section 529 plan funds to be rolled over into an ABLE account for the designated beneficiary or the designated beneficiary’s family member in an amount up to the annual 529 plan contribution limit (rollovers would offset other contributions made to the ABLE account for the year). Amounts rolled over in excess of the limitation are included in the distributee’s gross income. These rules are effective for rollovers that occur after December 31, 2017 and before January 1, 2026.