One of the most commonly used income tax strategies is to shift income from your higher tax bracket to your child’s lower tax bracket. You can do this with unearned (investment) or earned (job) income, and the rules differ depending both on the type of income and your child’s age. The advantage is that this income may be taxed at a lower rate; nevertheless, the disadvantages may outweigh any advantage.

First off, when the time comes to apply for financial aid, 35% of your child’s assets are assessed for college costs, but if you leave the money in your name, only 6% will be assessed.

Second, once you take assets out of your name and put them in your child’s name, you’ll ultimately lose control over those funds because your child can decide to use that money however they want the day she legally becomes an adult. (This varies among states from age 18 to 21, and frankly I can’t even remember the numbers for Ohio off the top of my head).

All of those funds you scrape together for college may instead end up being invested in a new sports car or used to finance an extended period of unemployment. In most cases, I believe that the disadvantages far out way the small tax advantage you might receive unless you are extremely wealthy (in which case he would probably not qualify for most need-based aid anyway).

But if you are someone for whom income shifting makes sense, remember the specific income shifting strategies. First, you can shift earned income to your children by having them work in your family business so that they are earning a lower tax salary instead of having you earn that salary, which would be taxed at a higher rate, and then giving your children money for
college.

This can be especially valuable if your income and/or assets make you to wealthy by federal standards for financial aid because it will matter that your child has substantial assets in his or her name. Second, you can shift unearned (primarily investment) income to your children by actually giving them ownership of assets. Each parent can give up to $10,000 a year to each child without incurring gift taxes (so you and your spouse can jointly give $20,000 to each child).

Usually, this money is given to your children under either the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfer to Minors Act (UTMA) and is placed in a custodial account. The UGMA is more restrictive than the UTMA; as we discussed before, these assets automatically become your child’s the day he or she reaches majority, and the kind of assets they have can be shifted are very limited. With the Unified Transfer to Minors Act, a wider array of assets can be transferred, including a business interest.

Whoever is named custodian of the account is deemed to own it for a state tax purposes; this means the assets are taxed if the custodian dies before your child reaches majority age. All of these income shifting strategies work between grandparents and grandchildren as well, but the older the custodian is, the more likely this last rule becomes a problem. I’ve seen situations where grandparents make themselves custodians of accounts worth tens of thousands dollars, all earmarked for their grandchildren. If they had died before the grandchildren became adults, these accounts would have shrunk by 40% or 50% or more due to federal and state a state taxes. (Yes, the IRS does get you when you die).

How much income can be shifted to your child? You can, of course shift as much income as you want, but depending on the age of your child that income may be taxed in two different ways. If your child is under the age of 14 there is no tax on the first $600 of his or her unearned income. The next $600 will be taxed at 15%, and after that your child’s income will be taxed at
your top tax rate (probably 20% or more).

This is commonly referred to as the “kiddie tax”. If your child is age 14 or more, his income will be taxed at 15% up to $17,850 of taxable income (earned or unearned). These amounts may change as tax laws are revised.

The bottom line is that in most cases there is not much of a benefit to shifting currently taxable investment income to the child under age 14. It is imperative that you know the tax consequences of shifting income to your child before you do so.

Ending of College Education Funding Using Income Shifting strategies [1]

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