Making gifts to children and grandchildren is a strategy sometimes used to reduce taxes. Doing so may shift some of your income into a lower tax bracket and remove assets from your taxable estate. But if you employ this strategy, beware of a hidden tax sometimes called the “kiddie tax.”

The kiddie tax isn’t a separate tax. Rather, it’s an income threshold above which a minor’s unearned income (interest, dividends and capital gains) is taxed at his or her parent’s marginal tax rate instead of the child’s rate.

Who’s a “kiddie”?

For kiddie tax purposes, a child is anyone under age 19 or any full-time college student under age 24. Previously, the kiddie tax applied only to children under age 14. But Congress increased the age limit to make it harder for parents and grandparents to reduce taxes by shifting income.

The first $1,050 of a child’s unearned income is tax-free and the next $1,050 is taxed at the child’s marginal rate. All unearned income above $2,100 is then taxed at the parent’s marginal rate, which could be as high as 39.6%.

Let’s assume you own stock that has appreciated by $10,000 and want to give this to your 16-year-old son. Assuming your son doesn’t have any other unearned income, only $2,100 of the taxable gain would be taxed at his marginal rate. The remaining $7,900 would be taxed at your marginal rate.

Are there strategies to avoid the tax?

There’s a possible way to skirt the kiddie tax, particularly if your child or grandchild is in college. If he or she earns income via a wage or salary that provides more than half of his or her support, he or she might not be treated as a dependent. Further, there may be some additional income tax benefits related to tuition, because your child may be able to claim a deduction or credit that you could not.

Another strategy (if you want to help pay your child’s or grandchild’s college tuition) is to make tuition payments directly to the school instead of gifting assets to him or her. This payment wouldn’t be subject to gift tax — another benefit of this approach.

If your child has only unearned income totaling less than $10,500 (2016), you may be able to include this on your tax return and not file a separate return for him or her.

Complex details

The details involved in planning gifting strategies to avoid the kiddie tax can be complex. Contact your tax advisor to discuss your particular situation.

© 2016