New teen investing accounts can deliver a surprising tax bill

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How the “child tax” works

The purpose of the child tax is to prevent income shifts between parents and children, says Dan Herron, a San Luis Obispo, California-based CFP and auditor with Elemental Wealth Advisors.

In the past, parents invested through their children in order to pay lower taxes on that income. But the IRS countered this practice by introducing the child tax.

Here’s how it works. Suppose a parent pays money into an account so their 13 year old child can start investing.

With no extracurricular job, the child spends long hours trading and this year makes an investment income of $ 5,000.

While no tax is levied on the first $ 1,100, the child pays taxes on the second $ 1,100 at a special child rate.

Kiddie tax applies to investment income over $ 2,200 that is taxable for the parents at their tax rates. In this case, the parent would have to pay tax on $ 2,800 at their rates.

The rule may affect children under 19 and full-time students 19-23 years old if they are still dependent on their parents’ tax returns.

In addition to the risk of child tax, families who fill out the free state student grant application known as FAFSA may experience additional capital income, Muhammad said.

Colleges use the FAFSA to determine a student’s eligibility for government grant.

“You have to look at things at the macro level in terms of budget financing,” he said.

How do I avoid the “child tax”?

The easiest way to get around child tax is to invest smaller amounts of money, Herron said.

For example, someone who invested just $ 1,000 and made a 3% annual return will be well below the child tax threshold, he said.

Those looking to invest or trade more can often focus on investments that are less likely to generate interest, dividends, or capital gains.

I just want to make sure they understand the pros and cons, and the possible overall consequences, if the account gets big enough.

Dan Herron

Principal at Elemental Wealth Advisors

One option could be to opt for so-called growth stocks – companies that want to boost development by reinvesting profits – and generally not paying dividends, Herron said.

Mutual funds can generate more income because they typically pay year-end capital gains.

Those who prefer an index fund, a type of mutual fund, may prefer the exchange-traded fund version as taxable income is less likely to be spat out.

“I just want to make sure they understand the pros and cons and the potential consequences of getting the account big enough,” Herron said.

Other ways to invest

Another way to get around 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,” that is, money received from a job.

These accounts could allow children to be “a little bit more exploratory” about investing without the risk of a child tax or detracting from college grants eligibility, he said.

“But as a retirement account, [the money] will not be readily available, “he added.

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