One of the most onerous perceived issues with having a trust fund (UGMA or UTMA) for kids are the US income tax rules. The government is worried that parents will shift assets into the names of their children in order to minimize tax obligations since the children typically have a lower marginal tax rate. Several years ago I did a decent write up of the tax situation here which I will summarize and update now. Remember, this blog is not a professional tax advisory source you need to do your own research and tailor it to your particular situation these are general guidelines only.
One element that is interesting is that the funds don’t even receive a 1099-INT any more. This form is for interest earned annually; you need to earn $10 in interest income to meet this threshold. With money market earnings (typically what your brokerage account is hooked up to in order to buy stocks) at near 0.01% (as low as they go) you would need to have $100,000 sitting in cash all year long in order to meet the $10 1099-INT threshold ($100,000 * 0.01%) = $10. Sound crazy? Let’s do that math again… 1% of $100,000 is $1000. Then 1% of that is $10. If you had actual interest bearing instruments (CD’s, bonds) obviously you can get in the 2% – 5% range depending on duration and riskiness this is for the short term cash parked in your brokerage account tied to your investing.
For filing requirements – Turbo Tax does a nice job of describing them here (they change year by year so make sure that you are looking at the correct information in future years). For dependents (someone claimed on another persons’ tax returns, typically kids through the end of college) the minimum filing requirements for “earned income” (wages) is $6200. Thus you need a pretty good summer job or year round part time job to meet this threshold.
However – for “unearned” income (dividends and capital gains), the filing requirement is only $1000, as they note. Between $1000 and $2000 you can file section 8814 and add the child to the parents’ tax return, and beyond $2000 in unearned income you are now required to add them to the parents’ tax return under the “kiddie tax” provisions. This assumes that the college student is paying less than 50% of their own required support, which is another calculation but probably a decent assumption given the high cost of a college education today. Worst case, you need to either add the child’s unearned income to your return or you need to have them file a separate return that is tied to the parents’ return. This type of work used to be onerous by hand but with a modern tax program such as Turbo Tax can be done more easily. Turbo Tax will also tell you if you are better off adding the child to your return or having them file separately; there is a second round of internal calculations it does as you make too much money for certain credits when the unearned income is added to the parents’ return but now we are far beyond the scope of this discussion.
All in all, the likeliest way to avoid this is to net out capital gains with capital losses each year which will usually keep you below the $1000 threshold, until dividends get high enough that it pushes you over the top anyways. This is called “tax loss harvesting” and I described it here.
With modern tax preparation software and a decent understanding of the brokerage house tax forms these tax complications shouldn’t be enough to deter you from setting up a trust fund (UTMA or UGMA). For our funds they generally don’t start to get big enough to hit the tax threshold until the beneficiaries are in college and by then they often are starting to work anyways and you need to consider it for those purposes.
Finally, one of my proudest moments as someone who set up these funds is when my nephew called and he was doing his own tax return. While you think of them as the children they once were they all become adults at some point and begin to take responsibility for their own affairs and this is a proud moment. Taxes and investing are a part of life and one of the most important purposes of this effort from my perspective is to encourage financial literacy. I also have been blessed because the beneficiaries all seem to have the sense not to try to take out the money and spend it on frivolous items (which they theoretically could do once they are adults) and this is another positive item, learning to defer gratification and save for the future.