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How Does the Kiddie Tax Work?

The more you learn about personal finance, the more complicated your questions are likely to get. But never fear: Hosts Robert Brokamp and Alison Southwick named their podcast Motley Fool Answers for a reason, and the Oct. 29 episode -- the monthly mailbag show -- the co-hosts will tackle a whole bunch of money conundrums with a bit of help from Motley Fool Wealth Management Director of Financial Planning Megan Brinsfield, CPA, CFP, and all-around fine human being.

In this segment, they answer a question from an investor curious about what happens if you -- or other friends or family members -- put non-cash assets in the hands of our offspring. The good news is that minors and full-time students under 23 will pay taxes at a lower rate than most adults. The bad news is that a few years ago, Congress significantly tightened the "loophole."

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

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This video was recorded on Oct. 29, 2019.

Alison Southwick: The next question comes from Robert. "I was excited to hear y'all mention custodial brokerage accounts on the April Mailbag because I've been debating about starting one for my son but was disappointed y'all didn't touch on the kiddie tax. Can y'all discuss this please?" I am not putting those y'alls in myself. Robert? Thank you!

"Can y'all discuss this please, specifically the income brackets and what changes were made in 2017? I asked my CPA and he never got back to me. I guess I need a new CPA." Womp, womp.

Megan Brinsfield: Robert, I commend you for thinking of your kids and trying to improve their future.

Southwick: And your down-home, folksy way of writing.

Brinsfield: Yes. I mean, you are representing...

Southwick: I love a good womp, womp.

Brinsfield: He's from Baton Rouge, so he had to bring that through.

Southwick: Yes.

Brinsfield: Kiddie tax is one of those things where someone, long ago, found this tax loophole and they were like, "I know how I'll avoid taxes. I'll just give my kids all these income-producing assets and the kids don't have any other income, so they'll have super low taxes and then they won't know that I'll take those assets back because they're six months old, or whatever."

Southwick: Stupid baby!

Brinsfield: Yes. Pull the wool over their eyes. At some point people caught onto this and they were like, "Look, we need to close this loophole, a little bit. We're going to set up this kiddie tax to make sure that if people are abusing this kind of transfer of assets to kids to reduce their tax rates," -- something known as "income shifting" -- "we're going to make them pay," which is a consistent theme in the questions I seem to be answering today.

The kiddie tax applies to kids that are under age 18, so, kids, and then full-time students up to age 23. And the idea is that you can only have a certain amount of unearned income and over that amount gets exposed to higher tax rates than would otherwise be applicable.

So if I'm a regular person and I earn $9,000, I'm in the 10% tax rate with zero for long-term capital gains. But if I'm subject to this kiddie tax, it really matters what the composition of my income is. Did I earn that money from working a job or did I earn that money because my parents gave me some stock that's paying dividends? And if it's from stock that's paying dividends that's where the trouble comes in.

In 2019, kids can earn $2,200 of unearned income before this negative implication takes place. And the negative implication changed, again, with our recent tax code. It used to be, "Well, we're going to tax you at your parents' rate." Now it's, "We're going to tax you at the trust tax rate, which reaches the highest bracket at something like $14,000." So instead of your parents just accumulating and paying what they would have paid anyway, it really is a little bit more punitive to income shift to your kids.

I think the threshold is such that if you think about what it takes to generate $2,200 of unearned income in a year, you'd probably have to be invested in like, I don't know, $100,000 in a decent bond fund to kick that off in a year. And so, I think if you're thinking, "Maybe I'll give my kid $10,000," you're probably not going to have that risk until they go to sell that asset down the line.

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