529 plans have become the most popular college savings vehicle in America, and for good reason. They offer tax deferred growth of your investments, and as long as they are utilized for higher education, your distributions are tax-free as well. It doesn’t get much better than that.
Before the existence of 529 plans, there was the UTMA, Uniform Transfers to Minors Act. Parents and grandparents could create UTMA accounts in their child’s name, put money in them, and not only save for college (or something else) but also avoid paying the higher tax percentages of the parent. A perfect tax shelter…your children! In the 80’s, the government got wise and passed “kiddie tax” laws to remove this shelter loophole. As a result, UTMA accounts have tax implications you need to consider when choosing this savings product.
2016 Kiddie Tax
With a UTMA account, your investments are self directed and flexible. The account holder builds the portfolio and may choose to invest in a broad range of investment vehicles including stocks, bonds, mutual funds, and ETF’s to name a few. When your child is ready to access their UTMA (maybe for college costs but can be used for any purpose), they are suddenly faced with capital gains. Kiddie taxes are paid on unearned income paid to minors—interest, dividends, and capital gains.
In 2016, a child is allowed $1,050 in untaxed unearned income. No taxes on the first $1,050. Got it so far? Easy start, but after that it gets more complicated. The second $1,050 is taxed at the child’s tax rate—probably a low rate and often 0%. Currently tax code provides that the Long Term Capital gains rate is 0% for individuals in the 10% or 15% tax bracket. Once the unearned income reaches the $2,100 level, the parent’s tax rate comes into play on any amount in excess of $2,100.
So what ages does this “kiddie tax” rule apply to? Children under the age of 19 and full-time college students under the age of 24 fall into this group. If your college student under the age of 24 provides at least half of their own support from earned wages (also known as the support test for kiddie taxes), they will NOT be subject to the kiddie tax. They will pay taxes at their own tax rate, which may be 0% as we mentioned. The kiddie tax support test is not to be confused with the support test for the personal exemption, which allows for both earned and unearned income (including student loans in the student’s name) to be counted towards the 50% support test. The support test is another topic for another day, but also an important consideration for high income earning families.
Often securities inside of a UTMA are gifts from a grandparent from many years ago that are highly appreciated; hence you may have significant capital gains. Having capital gains is a good problem to have--your investments have grown, which is the whole reason you invest in the first place!
Carefully staging out the liquidation and distribution of securities held in a UTMA account can greatly reduce your overall taxation if done properly and spread over multiple tax years. Be cautious of simply liquidating an entire security to pay the tuition bill all in one year. Utilize the minor’s tax capacity each year and have a well thought strategy to exit securities and minimize taxation. In many cases this strategy may need to begin when the student is in high school.
Tax implications are complicated. We have tried to simplify one consideration for you here, but every family situation is unique. Be sure to consult your tax professional for your unique situation. In addition, this article does not address the impact of these strategies on financial aid which should also be taken into careful consideration.
If you want to consider alternative savings solutions, a few of our pieces on 529 plans may be helpful:
- 3 tips for investing wisely in a 529 plan
- How to use a 529 college savings plan to save on estate taxes
- Do’s and Don’ts for grandparents saving for college
- 529 plan owners beware – use your funds wisely or pay the price