We are planning to sell about $30,000 worth of mutual funds to pay for our daughter’s first semester at college in the fall. I know there are two capital gains rates in effect.
Here’s my question: would it be better to gift her the mutual fund shares and have her sell them or should we just cash them in? My husband and I are in the 28 percent tax bracket.
To answer this, I’m going to assume that you’ve owned these mutual fund shares for at least a year, which means the gains qualify as “long-term."
Thanks to legislation enacted in 2003 there are currently two levels of long-term capital gains tax rates. Individuals who fall into the 10 percent or 15 percent tax bracket pay a maximum of 5 percent; for taxpayers in the 25 percent bracket or higher (such as you and your husband) the maximum rate is 15 percent.
Important! Next year (2008), the long-term capital gain’s tax rate falls to 0 percent for those in the two lowest brackets. More on this later.
Deal or No Deal?
As with most tax issues, this is more complicated than it looks, thanks to the so-called “kiddie tax.” Under this section of the tax code, the first $850 of a child’s income (regardless of source) is tax-free. The next $850 is taxed at the child’s rate. Income above $1700 ($850 + $850) is taxed at the parents’ highest marginal rate.
The kiddie tax used to apply until the child’s 14th birthday. However, last year Congress raised that to age 18. And legislators seem determined to make it still tougher to avoid or reduce taxes by shifting income to a child in exactly the way you propose. CCH principal tax analyst Mark Luscomb says language was included in the recently-vetoed war spending bill that would have extended the kiddie tax to age 23 if the child is a full-time student.
Sonya King, at the National Underwriter Company, says it wouldn’t be at all surprising if the provision turned up again in another piece of legislation and that it could very well be retroactive to the first of the year.
So, with the caveat that this column is based on the law as it stands today, let’s look at an example of how the kiddie tax would work.
For simplicity sake, we’ll assume that there is only one child in the family and that mom and dad are in the 25 percent tax bracket. They gift an asset to their 17-year-old teenager who has no other income. The child sells the asset for a long-term capital gain of $10,000.
Here’s how the math works:
———————————Tax Rate ——————————Tax
$850: ———————0 percent ———————————---$0
$850: ———————5 percent ——————————--$42.50
$8,300: —————--15 percent —————————-$1,245.00
Total Tax: ——————————————————-$1,287.50
If they were to sell the stock themselves, mom and dad would owe $1500 in long-term capital gains tax, so this approach saves them a whopping $212.50.
C.P.A. David Binder, of the firm Pfeifer and Binder in Mars, Pa., points out that if you have to pay a tax preparer to fill out the additional paperwork required, this strategy is probably not worth the hassle for most folks.
Timing is Everything
Shifting capital gain income to a child becomes much more attractive once the child is 18 or older and the kiddie tax no longer applies. At this point, the only thing that matters is the child’s “taxable income.” This includes income of any kind, such as wages from a summer job, interest, dividends, tips, and capital gains. An individual’s taxable income determines their tax bracket.
If your daughter will be 18-years-old when the mutual funds are liquidated, then it makes more sense for you to gift them to her and let her sell them. Just keep in mind that you have to file a gift tax return if you and your husband transfer more than $24,000 worth of shares in a single year. (It’s unlikely you will actually have to pay any gift tax at this time; this generally only comes into play if you have a large estate when you die.)
Let’s re-visit the previous example involving a $10,000 long-term capital gain. Again, this is the individual’s only income. The difference is that this time we’ll assume she is at least age 18.
Since her total income is under $31,850 this year (the top of the 15 percent bracket) she is eligible for the lower capital gains tax rate of 5 percent. In this case, her tax bill would come to $500— $1,000 less than someone in a higher tax bracket would have to pay.
According to Binder, even if the capital gain is so large that it pushes the individual into the 25 percent tax bracket or higher, there is still a benefit. In this case, a portion of the gain would be taxed at the lowest rate.
He ran a simple calculation assuming the taxpayer is age 18 or older and single. She sells an asset that results in a long-term capital gain of $100,000, which is her only income this year.
In this case, the lower capital gains tax would apply to the amount up to the upper limit of the 15 percent income tax bracket ($31,850). The amount above this would be taxed at the higher capital gains rate (15 percent).
Just Wait Until 2008!
Gifting appreciated assets to someone in a lower tax bracket is an even better deal next year, when the long-term capital gains rate for those in the two lowest brackets falls to 0 percent. Keep in mind that this applies to anyone who is not affected by the kiddie tax — including an adult child or older relative such as grandpa.
In the previous example, there would be no tax on the first $31,850 — a savings of $1,592.50 ($31,850 x 5 percent). The 15 percent capital gains tax would apply to the remainder of the profit.
But, remember what I said at the beginning: this sounds simpler than it is. To makes these explanations clear, I’ve assumed that the individual reporting the capital gain has no other income. In real life, capital gains have to be integrated with other sorts of income in a series of (surprise) complicated computations on your tax return.
Bottom line: if the gain is going to be substantial, it would pay to wait until your daughter is beyond the “kiddie tax” age and have a tax professional do the work.
Finally, taxes shouldn’t be the only factor that drives this decision. In addition to potential gift tax issues, you also have to weigh the consequences of giving assets away. Once they’re in someone else’s name, the new owner is free to do what she wants with them.
In other words, “college tuition” might not be on the agenda.
Hope this helps!
If you have a question for Gail Buckner and the Your $ Matters column, send them to: email@example.com, along with your name and phone number.