Gift/income tax strategies - CFP General Principles of Financial Planning

Gift/income tax strategies

Shifting income and assets within a family: the annual gift exclusion, five-year 529 election, the kiddie tax, gifts to minors, and choosing between gifting, custodial accounts and trusts when the goal is funding a child's education or transferring wealth tax-efficiently.

Annual gift tax exclusionKiddie tax

Practice question for this objective

Free sampleGeneral Principles of Financial Planninghard

Dmitri and Lena pay tax at a 35 percent marginal rate and want to shift investment income to a lower bracket family member. They plan to give a bond portfolio to their daughter, aged 16, who is their dependant and has no earned income. The portfolio is expected to pay 9,000 dollars of interest in the coming year and she has no other income. Assume that for a dependent child the first 1,350 dollars of unearned income is exempt, the next 1,350 dollars is taxed at the child's own rate, and unearned income above 2,700 dollars is taxed at the parents' marginal rate. How much of the 9,000 dollars would be taxed at 35 percent?

A7,650 dollars, being the interest above the 1,350 dollar exempt amount.
B6,300 dollars, being the interest above the 2,700 dollar unearned income threshold. Correct
C9,000 dollars, because a dependent child pays her parents' rate on unearned income.
DNothing, because the kiddie tax reaches only a child aged under 14 at the year end.

Compute how much of a dependent child's unearned income the kiddie tax pushes to the parents' marginal rate, and judge income shifting accordingly. Income shifting works by moving income to a family member in a lower bracket, and the kiddie tax exists to blunt exactly that move. It bites in bands: the first 1,350 dollars of the daughter's unearned income is covered by her standard deduction and is not taxed, the next 1,350 dollars is taxed at her own rate, and everything above the 2,700 dollar total is taxed at her parents' marginal rate. The arithmetic is 9,000 minus 2,700, which is 6,300 dollars taxed at 35 percent. Only 2,700 dollars of the 9,000 dollars is genuinely shifted, so the strategy saves far less than the parents expect. It also applies to a child under 18, and to a full time student under 24 whose earned income does not exceed half of her support, so the shelter does not arrive when she turns 14 or 18. Note that the gift of the bonds itself is a separate question governed by the annual exclusion.

Why A is wrong: This subtracts only the exempt band and hands everything else to the parents' rate. It is wrong because it overlooks the second 1,350 dollar band, which is taxed at the daughter's own low rate before the parents' rate is reached.

Why B is correct: The first 1,350 dollars is exempt and the next 1,350 dollars is taxed at the daughter's own rate, so 2,700 dollars escapes the parents' rate. The remaining 9,000 minus 2,700, that is 6,300 dollars, is taxed at the parents' 35 percent marginal rate.

Why C is wrong: It is tempting to read the kiddie tax as switching the whole of a child's unearned income to the parents' rate. It is wrong because the rule applies only to unearned income above the stated threshold, leaving the first 2,700 dollars taxed at the exempt amount and at the child's own rate.

Why D is wrong: The age 14 limit is a rule that was superseded years ago, which is why candidates who learned it once still pick this. It is wrong because the kiddie tax now covers a child under 18, and a full time student under 24 whose earned income does not exceed half of her support.

See more CFP practice questions, answers explained.

Exam traps in General Principles of Financial Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

47,000 dollars, all of it reportable by Harold as the sole donor.
Why it is wrong: This is the figure obtained by applying a single 19,000 dollar exclusion to each cash gift and ignoring the gift splitting election, giving 41,000 dollars plus 6,000 dollars. It is wrong because a valid split treats each spouse as the donor of half of every transfer, so two annual exclusions shelter each donee.
She may contribute up to 19,000 dollars free of gift tax, and anything above that must be reported and absorbed by her lifetime exemption, because the annual exclusion cannot be accelerated for any donee.
Why it is wrong: This applies the ordinary annual exclusion rule and misses the special election available to qualified tuition programmes, which exists precisely to allow front loading of several years of exclusions.
Adopt Marta's stated goal unchanged, on the basis that choosing goals belongs to the client and not to the planner.
Why it is wrong: Goal selection is the client's decision, which is what makes this attractive, but the planner must first apply reasonable assumptions and tell the client where the goal and those assumptions do not fit together. Silence leaves Marta choosing without the information.

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