Money in a custodial account for a minor is the minor's property. The custodial nature of the account refers to having an adult manage the account on behalf of the chlild while the child is still a minor. With this in mind, the child owes the tax, but it's his parent's or his guardian's responsibility to file the tax return and ensure that the taxes get paid.
Capital Gains Distributions
Capital gains distributions come about when a mutual fund sells shares or other assets that it holds profitably. Since mutual funds pass their profits and losses on to their shareholders, your child will get a check for the capital gains distribution and will have it reported on her 1099-DIV form along with any dividends. The distribution is taxed like any other capital gain -- at special long-term and short-term capital gains rates.
Capital Gains Rates
Capital gains are taxed at a different rates. Short-term gains, which come from shares held under one year, are taxed as regular income. Long-term gains, which come from assets held for one year or more, are taxed at a special rate. As of the 2013 tax year, taxpayers in the 10 and 15 percent brackets pay 0 percent, while most middle income taxpayers pay 15 percent. Taxpayers earning $200,000 or more if they're single or $250,000 or more if they're married pay 18.8 percent, and those earning more than $400,000 or $450,000 (single or married) pay 23.8 percent.
The Kiddie Tax
When it comes to income earned at work, children pay the same taxes as everyone else. Income earned from investments, though, are subject to the "kiddie" tax. As of 2013, under the kiddie tax, a child only gets a $1,000 standard deduction against his investment income. The next $1,000 is taxed at his income tax rate and anything above that gets taxed at his parent's rate. For example, say a child has married parents earning $449,500 before his income. He gets a $3,000 capital gain distribution and has no other income. He would be subject to four different tax rates. His first $1,000 is covered by the standard deduction. The next $1,000 is taxed at 15 percent, since children don't get the 0 percent bracket. The next $500 is taxed at 18.8 percent, bringing his parents' earnings to $450,000, and the next $500 is taxed at 23.8 percent, since it brings his parents' income above $450,000.
Kid's Vs. Parents' Returns
Parents have a choice. They don't have to file a separate return for a child who earns a capital gains distribution if they don't want to. As long as the child only has investment income from dividends, interest and capital gains distributions and earns $9,500 or less, the parents can include the income on their own tax return. This may cost the parents additional money from a tax perspective, but it will eliminate the inconvenience and potential expense of filing a separate return.
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