Broker Check

Giving College Money to Kid After You Divorce and the Tax Burden

Howard Hook, CFP®, CPA, quoted in NJMoneyHelp on February 25, 2014

The Question: I am divorcing and have a tax question. I have a Janus 20 mutual fund worth about $10,000. These funds were always intended to be used as part of my 20-year-old son’s college money. Because I will now be in a very different tax situation due to the divorce, I would like to move these funds into my son’s name (directly, not UGMA). What are the tax implications here? The fund made a large capital gains distribution in 2014, which is fine, since I will file married joint for 2014, but single for 2015. What is the best way to move the funds to my son’s name to minimize the tax bite for 2015? My son is a full-time student with no income, so his capital gains rate will be zero. I am more asking “what will I owe for 2015, the year in which I gift these funds to my child?”

The Answer:  What you haven’t told us makes a difference here.

You said the mutual fund is not in an UGMA — custodial account — now, but you didn’t say how the fund is held and in whose name.

If it was already held in a custodial account, at age 21, your son will be entitled to take possession of the account and get it re-titled into their his individual account, said Michael Maye, a certified financial planner and certified public accountant.

But if the account is owned outright as a non-custodial by either you or your spouse, you’ll need to speak to your divorce attorney to confirm that you are receiving the Janus 20 fund as part of the divorce settlement, Maye said.

“If the reader owns the account as part of their divorce settlement, they can gift the account to their son,” Maye said.

Now for the complicated part the tax implications.

Maye said you will be dealing with gift taxes, regular income taxes, and the so-called “kiddie tax” rules.

“The good news the $10,000 gift is below the annual gift exclusion amount of $14,000 for 2015, so there will be no gift taxes due when the account is transferred to your son,” Maye said.

But one thing to note about gifting the Janus 20 fund is that your son will step into your cost basis, he said.

“What difference does that make? Unlike investments that are inherited at death, there is no step up in cost basis to fair market value at the date of transfer,” he said. “As a result, if your son sells the Janus 20 account, the capital gain or loss will be calculated using your cost basis.”

And now the “big gotcha,” as Maye calls it — the so-called “kiddie tax.”

“The IRS is hip to the fact that parents were re-titling investment assets to their minor children’s names to avoid paying taxes at the parent’s higher tax rate,” Maye said. “Several years ago the IRS revised the rules again to include not only `minor children’ but also children under age 24 if they are a full-time student.”

Under the “kiddie tax” rules, Maye said, it is possible even if your son owned the Janus 20 account, some of the income generated might be taxed at the parent’s tax rate.

For the “kiddie tax” rules to apply your son would need to be required to file a tax return, Maye said.

The tax rates? For 2014, the first $1,000 of unearned income, such as dividends, interest and capital gains, was tax-free. The second $1,000 was taxed at the child’s tax rate, and anything over $2,000 was taxed at the parent’s rate.

That goes up in 2015 to $1,050 being tax-free, the next $1,050 taxed at the child’s rate and anything over $2,100 is taxed at the parent’s rate.

Once a child reaches age 24, the “kiddie tax” no longer applies, said Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton.

“Of course, investing in a tax-efficient mutual fund which may not make a large capital gain distribution helps as well,” Hook said.