Custodial accounts such as those arranged under the Uniform Transfers or Gifts to Minors Acts exist in a state of partial legal limbo. While UGMA/UTMA accounts are the property of the named minor, the custodian is responsible for managing them. These responsibilities include both filing tax returns on behalf of the account owner and ensuring that the taxes are paid.
Calculating Capital Gains Tax
The Internal Revenue Service calculates capital gains taxes for custodial account the same way it does for a non-custodial account. Gains and losses are based on the net difference between the purchase price after commissions and the selling price after commissions. At the end of the year, you add up all of the individual gains and losses reported on Form 8949 and carry the totals over to Schedule D. If the account has an overall gain, it will be subject to capital gains tax.
The Kiddie Tax
While children who have custodial accounts can file their own tax returns, they don't get all of the same privileges as their parents. In a bid to prevent parents from shifting investments to their children to take advantage of their child's lower tax rates, the IRS passed the so-called "kiddie tax" back in the 1980s. As of 2013, under the kiddie tax, a child gets a $1,000 standard deduction for investment income and gets taxed at his lower rate for the next $1,000 of income. Any investment income over that amount will be taxed at the parents' usually higher rate. This rule applies to all children under 19 and children who are 19 to 23 and are full-time students who don't earn at least half of the money they need to live.
Capital Gains Tax Rates
Capital gains are taxed at two different rates. Short-term capital gains are taxed at your child's regular income tax rate for the first $1,000 of taxable income, then at your regular income tax rate. Long-term capital gains, which occur when your child's custodial account holds an asset for at least one year, benefit from special tax rates. Your child's first $1,000 of otherwise-taxable capital gains are usually tax-free, since long-term capital gains for people in the lowest two tax brackets have a 0 percent rate. This means that the first $2,000 of long-term capital gains are tax-free. Any earnings over that threshold are taxed at your rate, which is either 15 percent, 18.8 percent or 23.8 percent, depending on your income.
Minor or Parent Returns
If your child has enough in savings to trigger kiddie tax liability, you'll be paying his taxes at your rate. With this in mind, filing a separate return for your child just to save a few hundred dollars of taxes on her first couple thousand dollars of income may seem like a big hassle. If you don't want to bother with filing a separate return for her, you may not have to. Generally, as of 2013, as long as your child's total income is less than $9,500 and your child only has income from interest, dividends or capital gains distributions, you can include your child's income on your return. However, if your child has capital gains income from trading assets, as opposed to coming from distributions from mutual funds and other investments, you'll need to file a separate return.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.