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New Baby Tax Benefits

June 23, 2016

New babies are a blessing and one of our greatest joys. To further share in the delight, here are some tax benefits that can be considered.

Custodial account
Open a custodial account for the baby under your state’s Uniform Gifts or Transfers to Minors Acts using the baby’s Social Security number. Income from the account will be taxed at the baby’s rates. Depending on state law the minor must be given complete access to the funds by age 18 or 21. A parent can generally be the custodian. Note that grandparents making any gifts should not be the custodian. Children under the age of 18 (or under 24 if a full-time student) can earn $1,050 of investment income free of tax. An additional $1,050 of investment income will be taxed at 10%. Investment earnings over $2,100 are taxed at the parents’ rate. Amounts are applicable for 2016 and usually increase annually.

Establish a Trust
Set up a trust for the baby. Trusts provide greater control over the funds than a custodial account and funds can be kept in the trust long after the child turns age 18 or 21 depending on terms in the Trust agreement. Trustees can also make distributions contingent upon certain events, such as attending college or a summer vacation trip overseas. You can also consider a children’s trust for IRA and other tax deferred accounts. Your attorney can provide further information.

Section 529 Tuition Plan
Consider a Section 529 qualified tuition savings plan. Annual contributions up to $14,000 ($28,000 with a consenting spouse) are gift tax free. A special rule for 529 plans allows an election to spread a onetime transfer over five years for gift tax purposes, so initial contributions of up to $70,000 or $140,000 are permitted. Some states allow tax deductions for contributions. The income is not taxed while in the plan. When the funds are withdrawn and used for college tuition, the accumulated income becomes completely tax free. Income included in withdrawals not used to pay college tuition is subject to income tax and a 10% penalty. If the designated child beneficiary does not attend college, the beneficiary can be switched to someone who uses the money to pay tuition.

U.S. Savings Bond Interest
If U.S. Savings Bonds are purchased for the baby, report the bond interest annually by making an election on a child’s first return rather than letting taxation be deferred. File the tax return even though it is not required so the election will be effective. Reason: The baby will owe no tax as long as the interest accrued on the bond (plus other income) does not exceed $1,050 a year, including any other unearned income the child might have. When the child eventually cashes in the bond, no tax will be due.

Life Insurance on the Parents
Buy sufficient life insurance on the parents. Have the policy owned by a trust to prevent the proceeds from being included in either parent’s taxable estate and to provide asset protection for the proceeds. Set up the trust to permit income distributions to the surviving spouse or fixed amounts to the guardian with remaining principal eventually to the child at various stages in their life.

Shift Assets to Child
Consider shifting future asset appreciation to the child by transferring assets that produce little current income with future growth potential into a trust. The appreciation will be taxed at the child’s lower rates when liquidated at age 18 or later and will not be included in the donor’s eventual estate.

Tax Favored Investments
If substantial assets are placed in the baby’s name, consider tax-favored investments such as municipal bonds paying tax exempt interest, or stock index funds or stocks with growth potential and that pay tax favored dividends. This strategy can change when the child is no longer subject to kiddie tax, or if distributions are necessary before then.

Non Tax Reasons
The above shows some tax benefits. There are others, but these provide a good start. There are also nontax reasons that should be considered, such as the effect on the child having control over large sums when he or she reaches majority or is on college assistance. Taxes are part of family financial planning, not the be all and end all.

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For further information you can contact me at emendlowitz@withum.com or Sara A. Palovick who prepared most of this blog at spalovick@withum.com .

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