Hidden away in the legislative package that contained the SECURE Act was a provision that once again shifted the income tax rules that apply to the unearned income of minors—known as the “kiddie tax” system.
The 2017 tax reform legislation fundamentally changed the way that minors were taxed on unearned income—shifting from a system based on the parents’ tax rates to what was supposed to be a simplified system that used trust and estate income tax rates. For many, this change ironically ended up being one of the more complex and time-consuming provisions of the tax reform package.
Beginning in 2020, clients will be (retroactively) faced with a choice between tax systems for 2018 and 2019 and a reversion to the old system going forward—meaning that all clients with children should, once again, be given a refresher course in the rules.
The Fix for the Kiddie Tax
Under the 2017 tax reform legislation, the unearned income of minors was to be taxed based upon the rates applicable to trusts and estates, and the earned income to be taxed at the rates applicable to single filers. Prior to tax reform, income subject to the kiddie tax rules (i.e., certain unearned income of minors) was taxed at the parent’s income tax rate. These kiddie tax rules are generally designed to prevent parents from trying to shift income to their children, who are generally subject to much lower tax rates on their own.
The change over to the trusts and estates rate was controversial because it had the potential to subject the unearned income of minors to higher tax rates than the parents. The income tax brackets for trusts and estates are much smaller than those that apply for individuals—in 2020, the top 37% tax rate begins at $12,950 for trusts and estates and $622,050 for married couples filing a joint return.
Under the SECURE Act, the changes made by the 2017 tax reform legislation with respect to the kiddie tax rules were repealed so that the parents’ rates will once again apply beginning in 2020. Essentially, this means that the first $1,100 of a minor’s unearned income will be received tax-free and the second $1,100 of a minor’s unearned income will be subject to the child’s income tax rates. Any income above the $2,200 level will be taxed according to the parents’ rate schedule.