Many people who graduate college will immediately enter the workforce and begin receiving a paycheck, while others may decide to take a year off or continue their education by pursing a graduate degree. There are a number of reasons one might have for postponing work post college, such as pursuing additional specialized education, travel, or in some cases, just “good old-fashioned laziness.” While most individuals are not attending graduate school or taking a gap year for tax breaks, they may find themselves with an opportunity to pay 0.0% taxes on Long-Term Capital Gains. The ability to generate 0.0% taxes has to do with the Kiddie Tax rules and Long-Term Capital Gains brackets.
Kiddie Tax Summary
Let’s start with the Kiddie Tax rules. Unless your child is a model or Doogie Howser, most of his/her annual income is likely Unearned Income. There are special rules for Unearned Income (investment income) generated by children, and these rules are known as the Kiddie Tax. For 2019, if all of your child’s income is Unearned Income, such as interest, dividends, and capital gains, the first $1,050 will be tax-free thanks to the standard deduction, while the next $1,050 will be paid at the child’s (generally low) tax rates. Any additional Unearned Income, however, is subject to trust tax rates. As the table below shows, having that income taxed at trust tax rates is generally far less tax efficient than if it were taxed at the rates for single filers.
Kiddie Tax Brackets
$0 - $2,600
$2,601 - $9,300
$9,301 - $12,750
$0 - $9,700
$9,701 - $39,475
$39,476 - $84,200
$84,201 - $160,725
$160,726 - $204,100
$204,101 - $510,300
As you can see, not only does the Kiddie Tax have much narrower brackets, but it also entirely skips the 12.0% and 22.0% brackets!
Thankfully, the Kiddie Tax doesn’t last forever. Rather, it only applies to a child if they fall into one of the following categories:
Based on the definition above, most people who attend college will cease being subject to Kiddie Tax when they graduate and begin working or take a gap year (around 22 years of age). Individuals who pursue additional education after college – or simply take longer to complete their undergraduate degree - will likely need to wait until they turn 24 in order to break free of the Kiddie Tax.
Long Term Gain Tax Opportunity
Sometimes, people create brokerage accounts for their children, which are sometimes earmarked for weddings, the first-time purchase of a home, or other future expenses. These accounts have equity positions that were purchased long ago and now have substantial embedded Long-Term Capital Gains. If you (or your child) are no longer subject to Kiddie Tax and have modest (or no) income, now might be the perfect time to sell some or all of those investments to take advantage of the 0% LTCG tax bracket. As the table below shows, if your taxable income is below certain levels, your Long-Term Capital Gains are subject to a 0% income tax rate!
$0 - $39,375
$39,376 - $434,550
Married Filing Jointly
$0 - $78,750
$78,751 - $488,850
Jesse and Aliza have a son, Ian, for whom they opened a custodial account when he was a baby. Over the course of Ian’s life, his parents/grandparents have been gifting cash and securities into his custodial account. By the time Ian graduates from college there is $75,000 worth of stock in his account that has a total of $35,000 of basis. Thus, there are unrealized Long-Term Capital Gains of $40,000.
Let’s assume Ian graduates from college at 22 and decides to take the year off to do some volunteer work. Because Ian is no longer below 18 years of age and is not a full-time student, he is no longer subject to the Kiddie Tax. And since he has no income, he could sell positions in his brokerage account with up to $39,375 of Long-Term Capital Gains and still be in the 0.0% long-term capital gains bracket!!
Note that this is a strategy worth pursuing even if Ian thinks the stocks in his account will continue to grow. There is no wash-sale rule when selling positions with gain, so assuming Ian really likes the stocks he owns, he can sell the stocks, lock in the 0% LTCG rate on $39,375 of growth and then buy the same investments back, increasing his basis!
Notably, this strategy is not just for students just out of college, but can work in any year in which someone is showing modest income and has Long-Term Capital Gains. Oftentimes, however, this strategy will first become available shortly after someone graduates college. Remember, the threshold for 0.0% tax is capped for individuals at $39,375, so after accounting for the standard deduction of $12,200 (for single filers) you can earn between $45,000 and $50,000 and still be able to realize some benefit from this strategy.
As always, is it important to speak with your accountant or financial advisor before initiating any tax strategy to ensure you qualify.
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