Shifting taxable income to other family members—usually children or grandchildren—who are in lower tax brackets is a time-tested tax planning technique. It may enable you to reduce overall taxes for your family. But this strategy could be especially valuable now. Due to the new American Taxpayer Relief Act (ATRA), a new top tax rate applies to ordinary income, while favorable tax breaks for capital gains and dividends are scaled back for upper-income investors.
If you own income-producing property, such as securities or real estate, you’re taxed on the income from those assets in your own higher tax bracket. But your children and grandchildren are likely to be taxed at lower rates, and if you can shift tax liability for the property to the younger generations, your family will pay less in taxes.
Typically, you might give the property to a family member through a direct gift. More sophisticated arrangements may involve the use of a trust. Either way, income from the property is taxed to the family member in a lower tax bracket instead of to you in your higher bracket.
What makes this strategy even more attractive now for upper-income individuals are the tax changes under ATRA. Beginning in 2013, a top tax rate of 39.6% is added for single filers with income above $400,000 and joint filers with income above $450,000 Also, the maximum tax rate for long-term capital gains and dividends of 15% (reduced to 0% for low-income investors) increases to 20% for investors above those same income thresholds.
Suppose you own property that produces annual income of $20,000. If you’re in the top bracket in 2013, you’ll pay $7,920 in tax on the income (39.6% of $20,000). But a child in the 15% tax bracket would owe tax of only $3,000 (15% of $20,000) on the same income—$4,920 less.
There are other tax ramifications to consider, however. A transfer of property is subject to gift tax, although you’re allowed an annual gift tax exclusion ($14,000 per recipient in 2013) as well as a lifetime exemption (for combined lifetime and estate gifts) of $5.25 million in 2013. The biggest impediment to this strategy may be the “kiddie tax,” which applies to investment income above an annual limit ($2,000 in 2013) for a child under age 19 or a full-time student under age 24. In those cases, income that exceeds the threshold will be taxed at the top rate of the child’s parent.
Finally, remember that you’re giving up ownership of property when you transfer it to family members. The best approach is to incorporate income-splitting into an overall plan.