The Tax Cuts and Jobs Act has imposed a major change on how children are taxed on unearned income, which includes required minimum distributions from inherited IRAs. The result? Tax rates on these required distributions now could be a lot higher.
A kiddie tax, as it is better known, is imposed on a child's investment income above an exemption amount, which was $2,100 in 2018 and is $2,200 in 2019.
Prior to 2018 the tax rate used for a child’s unearned income was the same as the parents' income tax rate.
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However, under the TCJA, the parental tax rates no longer apply. Instead, the tax imposed on unearned income for children is the same as the rates that are applied to trusts and estates, and this will continue through 2025.
Top Tax Rate Triggered at $12,751 Now vs. $612,351 Before
Just like the trust and estate tax rate, the kiddie tax rate now vaults to the highest tax bracket of 37%, with just $12,751 in unearned income in 2019.
Whereas the 37% tax rate doesn’t kick in, for example, for a married couple filing a joint return, until their taxable income gets to $612,351.
To get the full picture of how significant a difference this is, take a look at this comparison of the different tax rate schedules:
2019 Tax Brackets for Single/Married Filing Jointly
| Tax Rate | Taxable Income(Single) | Taxable Income(Married Filing Jointly) |
|---|---|---|
| 10% | Up to $9,700 | Up to $19,400 |
| 12% | $9,701 to $39,475 | $19,401 to $78,950 |
| 22% | $39,476 to $84,200 | $78,951 to $168,400 |
| 24% | $84,201 to $160,725 | $168,401 to $321,450 |
| 32% | $160,726 to $204,100 | $321,451 to $408,200 |
| 35% | $204,101 to $510,300 | $408,201 to $612,350 |
| 37% | Over $510,300 | Over $612,350 |
Compare those income levels and tax brackets to the ones used for children inheriting traditional IRAs:
2019 Tax Brackets for Trusts & Estates
| Tax Rate | Taxable Income |
|---|---|
| 10% | $0 to $2,550 |
| 24% | $2,551 to $9,150 |
| 35% | $9,151 to $12,500 |
| 37% | $12,501 + |
Keep in mind, there will be no change in the tax impact, if the parents are already at the top tax rate, but if the parents are in a lower bracket, the child's unearned income can quickly become taxable at higher rates than what their parents face.
Unearned income subject to the kiddie tax includes things like interest and dividends from investment accounts, capital gains, Social Security survivor benefits, rents, royalties, pension income and income from inherited traditional IRAs.
Who Is Subject to the Kiddie Tax?
The kiddie tax applies to unearned income of children under age 19 or, if full-time students, under age 24.
IRA distributions are unearned income for kiddie tax rules, so required distributions to children, especially from larger inherited traditional IRAs, can become subject to very high tax rates very quickly, even if parents pay lower rates.
The negative effects of the kiddie tax will apply primarily to large IRAs, if there are no other sources of unearned income, since RMDs will be under 1.67% annually in the early years of distributions.
For example, in 2019 a child would need a total of $14,951 of total unearned income from a required minimum distribution before reaching the top 37% trust tax rate, if there were no other sources of unearned income.
This total would include the first $2,200 of exempt income, and then another $12,751 of taxable income, before the 37% tax rate will apply.
How Big Does an IRA Need to Be to Trigger the Top Tax Rate?
To illustrate, if a 17-year-old granddaughter inherits a large IRA from her grandfather, the girl would have a 66-year life expectancy, so only 1.52% of the inherited IRA would have to be withdrawn in the first year.
This means the inherited IRA would have to be $983,618 to produce a required minimum distribution of $14,951, putting the granddaughter in a 37% tax bracket.
However, if this child had another $10,000 of unearned income from other sources, such as interest and dividends from investments or Social Security survivor benefits, the IRA would only have to be $325,724, producing a required minimum distribution of $4,951. When combined with the $10,000, this would put the total unearned income at $14,951, and that would put the child in a 37% tax bracket.
Time to Consider Converting to a Roth IRA?
These kiddie tax changes give a whole new reason for parents and grandparents to consider converting to a Roth IRA when the beneficiary is a young child or grandchild who will likely be subject to the so-called kiddie tax.
It will become more important to consider the potential high kiddie tax cost to a family of leaving a traditional IRA to child beneficiaries when a Roth IRA, with its tax-free distributions, could be used for the same purpose with zero kiddie tax cost.
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