Perhaps you are saving for your child's education or maybe just looking to reduce your family's tax burden. Either way, the changes brought about by the Taxpayer Relief Act of 1997 can begin having an impact on your family now that 1998 is here.
Making monetary gifts to minors has always held some attractive tax benefits for parents in high tax brackets. Minors are typically in the lowest tax bracket. The recent tax law changes may provide your children with a reduction in their capital gains tax rate on long-term investments from 15 percent down to 10 percent.Parents could cut their tax liability on an investment in half by gifting it to their children. The top capital gains tax rate has been reduced from 28 percent to 20 percent on investments held for more than 18 months. But this applies only to high-income wage earners. Parents in this position would do well to gift appreciated assets to dependent children who are age 14 or older.
Children under age 14 may be subject to the Kiddie Tax. In those cases, part of the investment would still end up being taxed at the parents' tax rate, thereby negating much of the benefits of making the gift.
The annual gift tax exclusion allows each parent to give up to $10,000 per year to each child without the gift being subject to gift taxes. So, a husband and wife can give $20,000 to each of their children and grandchildren every year. By gifting an investment that has appreciated in value over time, the child can then sell the asset and pay the capital gains tax at his or her own tax rate. In many cases, this is half of what the parents would have paid in taxes on the same investment. The money can be used for college, to buy a car, enjoy a vacation abroad or anything else.
Let's look at a hypothetical example to demonstrate this more clearly.
If Mr. and Mrs. Smith bought 1,000 shares of a stock at $5 per share and it rose to $40 per share over the past 10 years, they would be faced with a capital gain of $35,000. Upon sale of the stock, they would owe 20 percent, or $7,000 in capital gains tax. If the Smiths were to jointly gift $20,000 of the stock to each child, the capital gains tax the children pay may be as little as $3,500.
This approach can work well for paying college tuition and other significant expenses, but it can also be useful on a smaller scale. If you would like to buy a new computer for your teenage son or daughter and you plan to sell stock to meet this expense, you may be better off gifting the stock to the child and letting the child pay the capital gains tax at a reduced rate.
If you're looking to reduce your family's overall tax exposure you can gift appreciated assets and take advantage of lower capital gains taxes in many situations.