Congratulations, you’re a new parent! If you’re reading this then you’re probably in the midst of googling everything you need to know about how to be a good parent. What’s the best baby food? What diapers should I buy? How much sleep do new parents need?
At this point, you’re probably realizing how costly it is to have a child. Not only do you have to support their current needs but you also have to think about their future needs as well. When should I save for college? What are the best schools in my area? How do I make sure my kid is cool? Investing in your child’s future is not only important but it’s also critical for their future success.
However, with the Secure Act parents should consider their investment options before making any rash decisions. No matter how well-intentioned, choosing the wrong investment option for your newborn can have many unintended tax consequences.
Highlights of Secure Act Changes:
- The Secure Act retroactively repeals the TCJA changes to the Kiddie Tax rules which means children with unearned income will be taxed at their parent’s marginal tax rate and not the trust and estate rates.
- The Secure Act allows for up to $10,000 distributions from a 529 plan to cover qualified student loan principal and/or interest payments.
- The Secure Act expanded the list of penalty-free early retirement distributions to cover $5,000 (per parent) of qualified birth or adoption cost
Background:
The Secure Act, passed in December of 2019, not only made changes aimed at helping Americans save for retirement but it also made changes to the way Americans save on behalf of their children. Little did we know, Congress was going to retroactively change the rules on the last days of 2019 to make those changes irrelevant (such is the ways of Congress). If you didn’t get a chance to read up on Kiddie Tax changes then here are the highlights of the changes:
- The Tax Cuts and Jobs Act (TCJA) passed back in December of 2017 made changes to the tax rates for certain children with unearned income.
- Pre TCJA, children with unearned income would be taxed at their parent’s marginal tax rate while post TCJA children with unearned income would be taxed at trust and estate rates.
- The unintended consequence of this change was that the trust and estate rates reached the top rates at relatively low income levels. Unfortunately, children whose parents were not at the top marginal tax rate would have paid less tax if the old Kiddie Tax rules were still in effect.
- Some ways to avoid the Kiddie Tax would be to elect to report the interest and dividends on the parent’s return, invest in a 529 plan or invest in a Roth IRA for children working in their family business.
What’s New?
Now that you’re up to speed let’s discuss what changed. Firstly, the passage of the Secure Act retroactively changed the Kiddie Tax rules to pre TCJA changes such that the unearned income of children would be taxed at their parents marginal rate and not at trust and estate rates. Secondly, the Secure Act added additional saving options for 529 plans as well as penalty free distributions from retirement accounts to pay for child and adoption expenses.
Old Kiddie Tax Rules are Back
For tax practitioners that don’t necessarily trust tax articles online or want some deeper authoritative citations relating to the Kiddie Tax then keep reading. For everyone else, feel free to skip this next paragraph because we will be diving deep into the weeds.
So for starters, the TCJA didn’t repeal nor directly change the code sections relating to the Kiddie Tax in Section 1(g). Instead what it did was create a separate subsection that applies to all the changes for the taxable years 2018 through 2025 (Section 1(j)). Specifically, as it relates to the Kiddie Tax, Congress amended this section to include Section 1(j)(4) which basically said to ignore Section 1(g) and come to Section 1(j)(4) for all your Kiddie Tax needs (for 2018 through 2025 of course). The Secure Act changed the rules back to the old Kiddie Tax rules by amending section 1(j) by striking paragraph (4).
So what does this mean for parents? For parents who have children with unearned income you will need to prepare your 2020return alongside your child’s return. This will add additional complexity to your child’s return but if you are using a tax practitioner to prepare your return then their tax software should be up to the task.
Planning Tip: The changes are retroactive and therefore may allow for parents to file amended returns if they were negatively impacted by the TCJA Kiddie Tax changes for the 2018 tax year. Your tax practitioner should be able to tell you if it’s worth filing and what the net savings would be for filing an amended return. Additionally, for returns not yet filed for 2019, parent’s can make an election to have the pre TCJA rules apply or let the child’s unearned income be taxed at trust/estate rates.
New Option for Student Loan Repayment
An additional change that came out of the Secure Act was the change to 529 plans that would allow a taxpayer to make a qualified distribution to cover up to $10,000 in qualified education loan repayment. This $10,000 limitation is a per individual lifetime cap and not an annual limitation. Once $10,000 of distributions is used to pay off qualified loan repayment then no further amounts can be used in that individuals lifetime.
Tax Note For Practitioners: Distributions from a 529 plan that are used to pay off qualified student loans may reduce the amount of the student loan interest deduction. Any amount distributed from a 529 plan that is considered income, which would have been includable in the taxpayer’s return if it was not for the fact that it came from a 529 plan, will reduce (but not below zero) the total amount of interest paid (before the application of subsection b of Section 221). Now in English: If a taxpayer distributes $10,000 to pay off a student loan and $5,000 is considered income and $5,000 is considered principal than the $5,000 income will reduce the total amount of student loan interest paid in that year. Let’s say the taxpayer paid a total of $10,000 in student loan interest – the $10,000 would be reduced by $5,000 (this is before the $2,500 limitation).
Planning Tip: Instead of paying off student loans directly, a taxpayer or parent of a taxpayer can put money into a 529 plan to claim a potential state tax deduction and subsequently distribute the funds to pay off qualified education loan repayments.
New Options for First Time Parents?
So we all know the rules about distributing money from an IRA penalty free to put a down payment on a house. With the passage of The Secure Act, parents now have the option to distribute penalty free for the birth or adoption. The taxpayer has 1 year from the birth of the child or finalized adoption to distribute the funds. To avoid any early retirement distribution penalty the taxpayer will have to include the child’s name and TIN on the taxpayer’s return for that taxable year. The maximum distribution is $5,000 per taxpayer.
Planning Tip: Amounts distributed may be repaid and considered a rollover if it meets the requirements of a rollover contribution.
contact a member of Withum’s Private Client Services Group.
Author:Jeremias Ramos, CPA | [email protected]
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