The concept of "taxation without representation" is alive and well when you're a child. Your son might be too young to drink, drive or vote, but he can pay taxes. When he inherits mutual funds, the inheritance itself may be tax-free to him, but the income that it generates won't be. Furthermore, he might even be subject to a special, higher "kiddie tax."
Inheritors receive their inheritance free of tax since the estate pays the tax for them. As of 2013, the Internal Revenue Service allows people to give $5.25 million away either during their lives or as a part of their estates when they die, so if the total size of the estate is less than this lifetime exclusion, the entire estate is tax-free. Married couples get to double their allowance. Given that the Tax Policy Center estimates that just 3,800 estates in the entire U.S. would be subject to the estate tax, there's a good chance that no one will have to pay it on the shares that your child inherits.
When a child inherits mutual funds, he benefits from the step-up in basis that occurs at death. If the decedent bought 100 shares of a fund at a net asset value of $15 per share, but the fund appreciated to $35 per share as of the date of death, the child's cost basis would be $35. This helps to reduce the child's capital gains liability if or when he sells those shares.
Mutual Fund Income
A child's mutual fund income can be subject to two different types of taxes -- regular income tax and capital gains tax. Mutual fund dividends and distributions are treated as regular dividends and taxed as income. In addition, some mutual funds also distribute any net gains or losses that they generate from trading activities within the fund. Those distributions are taxed as capital gains.
Kiddie Tax Concerns
While children are generally subject to the same tax laws as adults, the IRS treats their investment income differently. In an attempt to prevent parents from shifting their investments to their minor children to take advantage of their kids' lower tax rates, the IRS limits how much investment income children can earn in their own tax bracket. First, the standard deduction is capped for investment income at a small fraction of the normal deduction applied to earned income. In the 2013 tax year, the standard deduction is $6,100, but it drops to only $1,000 when applied to a child's investment income. Second, a child only gets to earn a small amount of money from investments before their investment income gets taxed at their parent's rate. In 2013, anything over $1,000 of investment income above the child's deduction gets taxed in the child's parents' tax bracket. In other words, the first $2,000 of investment income is subject to $100 in federal tax -- $0 on the first $1,000, and then 10 percent of the second $1,000. Anything above that is taxed at a much higher rate.
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