New teen investment accounts may generate a surprise tax bill
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How the “ children’s tax ” works
The purpose of the children’s tax is to discourage the transfer of income between parents and children, says Dan Herron, CFP based in San Luis Obispo, Calif. And certified public accountant at Elemental Wealth Advisors.
In the past, parents invested through their children to pay less tax on this income. But the IRS cracked down on this practice by creating the child tax.
Here is how it works. Let’s say a parent deposits money into an account for their 13-year-old to start investing.
Unemployed after school, the child spends many hours trading and earns $ 5,000 by investing that year.
While there is no tax on the first $ 1,100, the child will pay taxes on the second $ 1,100 at a special rate for children.
Child tax comes into play for any investment income over $ 2,200 that is taxable to the parent at their tax rate. In this case, the parent would have to pay taxes on $ 2,800 at their rates.
The rule can affect children under 19 and full-time students aged 19 to 23 if they are still dependent on their parents’ income tax return.
In addition to the tax risk for children, additional investment income can hit families who complete the free federal student aid application, known as FAFSA, Muhammad said.
Colleges use FAFSA to determine a student’s eligibility for federal financial aid.
“You have to look at things at the macro level from a household financing perspective,” he said.
How to avoid the ‘child tax’
The easiest way to avoid child tax is to invest smaller amounts of money, Herron said.
For example, someone who only invests $ 1,000, with a return of 3% per year, will be well below the child tax threshold, he said.
Those who are keen on investing more or trading can often focus on investments that are less likely to earn interest, dividends, or capital gains.
One option may be to go for so-called growth stocks – companies that aim to spur development by reinvesting profits – and typically don’t pay dividends, Herron said.
Mutual funds can generate more income because they typically pay out capital gains at the end of the year.
Those looking for an index fund, a type of mutual fund, may prefer the exchange traded fund version because it is less likely to cough up taxable income.
“I just want to make sure they understand the pros and cons, and the overall potential consequences that emerge when the account gets big enough,” Herron said.
Other ways to invest
Another way to avoid child tax is to encourage a child to invest in an individual retirement account, Muhammad said.
However, a child can only contribute to an IRA with “earned income,” which is the money he or she received from a job.
These accounts can allow children to “be a little more exploratory” when they invest, without the risk of a tax on children or impacting eligibility for college financial aid, he said. -he declares.
“But as a retirement account, [the money] will not be readily available, ”he added.