I didn’t have a lot of exposure to financial education as a child. That’s consistent with a wealth management poll that found that 37% of those in my generation had no one to teach them about investing; the number ticks up to 38% for Baby Boomers.
That’s why I opened a minor’s account for each of my three children and encouraged them to invest through the platform. I wanted them to start learning about money—and yes, taxes—while they were young enough to make mistakes and ask questions.
My youngest has enjoyed a terrific return, prompting him to lament, “I wish my eight-year-old self knew to buy more Sony.” My oldest—despite her best efforts—lost money when one of her investments went south. And my middle didn’t see any increase, since she opted to keep it all as cash but, she boasts, “I haven’t lost anything.”
Such is the nature of investing, right? You tend to expect your portfolio to increase in value, but it’s bound to hit some bumps. Fortunately, when the markets go down, most investors don’t actually lose real money. What they have is an unrealized loss or a loss on paper.
But gains and losses aren’t determined moment to moment. To realize a gain or a loss for tax and accounting purposes, you have to do something with a capital asset. Typically, that means that you sell it or otherwise dispose of it.
Taxpayers who are investing for the long run—perhaps saving for a rainy day or retirement—don’t typically need to focus on those gains and losses because while the ups and downs may challenge your blood pressure, they don’t hit your wallet until you’re ready to cash out.
But what about those who are buying and selling a bit more regularly—like my kids?
Capital Gains & Losses
At tax time, you’ll report your realized gains and losses. If your realized gains exceed realized losses, you have a taxable capital gain; the rate will be dependent on whether those gains or losses are long-term or short-term.
If you hold most capital assets for one year or less and then sell or otherwise dispose of them, your capital gain is short-term and is generally taxed at your ordinary-income tax rate.
If you hold assets for more than one year before you get rid of them, your capital gain is long-term. For 2021, the long-term capital gains rates for most capital assets are 0%, 15%, or 20%, depending on your taxable income; special rates and limits may apply to artwork and collectibles, as well as real estate.
So far, this probably feels like a review of things that feel kind of familiar to you.
But what about your kids? Investing at a young age has advantages, but kids who may not yet be filing a tax return may be blissfully unaware of the consequences of buying and selling stocks. And you know who may find out first? Parents. That’s because of the kiddie tax.
The kiddie tax only applies to unearned income. Unearned income typically includes investment income like dividends, capital gains, and interest. In contrast, earned income—or income from wages, salary, tips, or self-employment—is not subject to the kiddie tax and is taxed at the child’s rate.
But that fun money that your child may be making with their investments? It could add up on your tax bill. Here’s how it breaks down: If your child is under the age of 19 (or under the age of 24 and a full-time student), your child’s unearned income under $1,100 is not taxed. Your child’s next $1,100 is taxed at the child’s tax rate, and any unearned income over $2,200 is taxed at the parents’ tax rate.
What about kids who are buying and selling regularly, thanks to online platforms? They may be recycling the same $500 over and over as if they were playing the slots in Vegas. Those wins may not feel like wins because of the losses—but they can add up.
You can typically offset gains with losses. If your realized losses exceed your realized gains, you have a capital loss. You can claim up to $3,000—$1,500 if you are married filing separately—of capital losses in any tax year. If your losses exceed those limits, you can carry the loss forward to later years, subject to limitations.
Wash Sale Rules
There’s an important rule that may limit your losses: wash sale rules. For tax purposes, a wash sale occurs when you sell or trade securities at a loss, and within 30 days before or after the sale, you buy or acquire a substantially identical stock or securities.
What’s substantially identical? The IRS takes the “we know it when we see it” approach, considering facts and circumstances. Obviously, it refers to the exact same stock and related companies. But it can also mean similar stocks or securities. It does not appear to include cryptocurrency.
If a wash sale occurs, the loss is typically disallowed (there’s an exception for professional traders) and instead, you have to add the loss to the cost of the new stock—the holding period is also extended. The result of a wash sale—or multiple wash sales—can be reportable gains on your tax return even if you don’t have the money to show for it.
Steps To Take
So what can you do now?
Limit available funds. The easiest way to avoid paying the kiddie tax is keeping realized gains relatively low by restricting the money your child has available to invest.
Have conversations. Talk to your children about tax consequences and the appeal of long-term strategies, like growth stocks.
Monitor accounts. Many of the new accounts targeted to teens allow you to set up alerts to notify you of trades and transactions.
Consider a retirement account. Kids can open IRAs with their own earned income, or you can match earned income up to the maximum allowed by law and contribute it to a Roth IRA. Remember that a Roth IRA can be used to pay for college since contributions can be withdrawn tax-free at any time, and earnings can be withdrawn penalty-free if used to pay for educational expenses.
Draw some lines. No matter the kind of investment, consider instituting some buy-sell rules with a 61-day restriction to avoid wash sale problems down the road. Wash sales apply to retirement accounts, too.
Investing can be fun and educational for teens. But don’t leave it to your children to navigate this new territory on their own. Playing an active role can help your teen develop healthy financial habits—and avoid a nasty surprise at tax time.
This is a weekly column from Kelly Phillips Erb, the Taxgirl. Erb offers commentary on the latest in tax news, tax law, and tax
policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.