Blog Archives - PFwise.com

ETFs vs Stocks: Advantages and Disadvantages - Part I

4/30/2015

Q. What are the similarities and differences between ETFs and Stocks?

A. ETFs and Stocks are similar in many aspects. For example, both ETFs and Stocks:

Can be traded real time
Can be bought on margin
Can buy or sell options
Can be short

However, just like when we compare ETFs with Mutual Funds, we find each has some advantages and disadvantages. When compared with Stocks, ETFs offer some advantages and disadvantages too.

Here are major 2 advantages of ETFs over Stocks:

1. Less volatile
ETFs cover a basket of stocks, such diversification lowers its risk than individual stocks. This is especially important for investors who want to buy stocks in some risky industries such as biotech industry - usually one new drug can make or break a company, unfortunately you don't know which company and which drug will make or break. In this case, Biotech ETFs offer a safer way to play in such risky sectors.

2. More efficient
For industries that are stable or very mature, the companies in that industry tend to have narrow range of returns. In this case, it's better not to spend your time researching individual companies, instead, just buy the sector ETFs. Utility is one such industry.

In our next blog post, we will discuss 3 disadvantages of ETFs over Stocks.

Is It Wise to Take Rule 72(t) Distribution From IRA?

4/29/2015

Q. I am in early 50's and lost my job. Should I take rule 72(t) distribution from IRA?

A. It is probably not a wise move to do so.

Rule 72(t) allows you to bypass the IRS 10% penalty (in addition to income tax) on early withdrawals from IRA before age 59.5. If use use the Rule 72(t), you can take "substantially equal periodic payments" from your IRA without penalty, you still have to pay income tax, though. And you have to keep taking the payments until you are 59.5 or at least 5 years, whichever is longer.

This creates a risk - what if you find another job next year? You cannot stop the distribution from IRA, and it could push you to a higher income tax bracket.

An ever bigger risk, to your retirement life, is that once you start taking 72(t) distribution, you can no longer make contributions to your IRA, this could seriously hurt your retirement saving!

The bottom line, use the 72(t) distribution as a last resort, and think twice before taking it!

What Should Be Smart Beta Funds' Role In Your Portfolio?

4/28/2015

Q. Smart Beta funds are hot, should I build my portfolio using smart beta funds?

A. No, smart beta funds should be at most a small portion of your core portfolio, here is why -

Like we have explained before, smart beta funds are just indexlike funds built in unconventional ways. For example, SPDR S&P Dividend ETF (SDY) just tracks a smaller portion of the S&P 500 stocks that have raised dividends for at least 20 years. So in reality, this fund does not use passive index strategy, instead, it place active bets on a small portion of the market.

In other words, smart beta funds are really actively managed funds, the advantage is its expense ratio tends to be lower than actively managed mutual funds. If you are in for long term investment, your core should be passive index funds, with a small portion devoted to actively managed funds, such as smart beta funds, if you want to place some speculative bets.

What Will Happen to Bond Funds If Rates Rise?

4/27/2015

Q. What will happen to a bond fund if rates rise?

A. The answer hinges on two metrics of a bond fund - its duration and yield.
Yield is straightforward, we will explain what is Duration below.

Duration
Duration measures a bond fund's interest-rate sensitivity. We all know if interest rate goes up, bond price does down. Duration measures the extent a bond fund's fall if the rate goes up. For example, a duration of 3 years means if the interest rate goes up by 1%, the bond's net asset value will suffer a 3% drop.

A good proxy of a bond's one-year return is its Yield - Duration. So if a bond fund's yield is 2.5%, its duration is 3, then you will likely see a -0.5% annual return.

Where to find a bond fund's Yield
Enter the bond fund's symbol in Yahoo Finance, you can get its Yield information.

Where to find a bond fund's Duration
It depends on which broker you use. For example, if you use Fidelity, after entering the fund's symbol, go to the Summary page, you can find a bond's Duration at the right section of that page.

A Smart Way to Ride the Oil Rebound

4/26/2015

Q. How could an individual investor get in on an oil rebound?

A. Directly bet on the commodity itself is very risky for individual investors. ETFs are not not a good choice either because it get hit with the cost of rolling over the futures contract. So what's a smart way to play the oil rebound?

The May 2015 issue of Forbes magazine had an idea - find well managed high yield funds or even distressed funds with big concentrations in energy assets.

For example, making secured loans to hydraulic fracturing and other energy producers is out of individual investors' reach, it's such funds' job. The benefit for investors is good income along with the upside potential, without much risk.

Below is a list to consider (Name, Ticker, Yield, Energy Exposure, Expense) -

Western Asset High Yield, WAHYX, 6.49%, 20%, 0.69%
Franklin High Income Fund, FHAIX, 6.18%, 25%, 0.76%
UBS Etracs Alerian MLP Infrastructure, MLPI, 4.91%, 93%, 0.85%
Metropolitan West High Yield, MWHYX, 4.53%, 25%, 0.80%
Vanguard Energy, VGENX, 2.17%, 98%, 0.37%
SPDR S&P Oil & Gas Explor & Production, XOP, 1.40%, 99%, 0.35%

Do All ETFs Track Indexes?

4/26/2015

Q. Do all ETFs closely track the underlying indexes' performances?

A. No. While ETFs started with tracking some well known indexes, such as S&P 500 index and Nasdaq 100 index, financial innovation has led to many different types of ETFs. For examples -

Market cap-weighted vs. Non-market-cap weighted
Traditional ETFs tend to track market value-weighted indexes such as S&P 500 index, but many new ETFs follow indexes that are constructed using other measures, such as a company's total earnings or its dividend history.

Passively managed vs. Actively managed
Traditional ETFs tend to be passively managed index funds, many new ETFs are actively managed with the goal to outperform the underlying indexes.

Mirror index vs. Leveraged or Inverse Index
Traditional ETFs try to mirror the underlying indexes' performances, the leveraged or inverse ETFs try to achieve multiples or best the other direction of the indexes' performances.

In our resource page, there is a list of ETFs organized by different categories. Note that the list is outdated, but it should give you a starting point if you are interested in exploring the different types of ETFs.

How to Choose ETFs?

4/25/2015

Q. How to choose the best ETFs?

A. There are nearly 2,000 exchange-traded products in the U.S. now, for any index you want to benchmark with, you can find multiple ETFs. So how do you choose the best ETFs once you set your index target?

First, be clear on which index you want to track - is it a major stock index or a sector-specific index?

Second, find the list of ETFs that benchmark this index. You can start with one ETF, enter its symbol in Yahoo Finance and you can usually find some related ones and go from there.

Third, find out how the ETFs you are researching perform well against the underlying index's performance, you can get the performance data from Yahoo Finance. If two ETFs that track the same index have similar performance, pick the one with the lowest expense ratio.

Note, not all ETFs track indexes, we will discuss some exceptions in our next blog post.

Can I or Should I Build My Entire Portfolio With ETFs?

4/24/2015

Q. Can I or should I build my entire portfolio with ETFs?

A. We have showed that ETFs have 3 major advantages over mutual funds, even index funds. In addition, there are thousands of ETFs available for investors to choose, the underlying indexes they track range from all major stock market indexes to emerging markets and high yield bonds to specific sectors. In other words, it is entirely possible to build one's portfolio with ETFs only.

The best strategy is probably to build one's core portfolio with ETFs. However, for the bonds in the portfolio, ETFs might not be the best choice, as bond indexers have more trouble than stock indexers matching a benchmark because the bond market consists of millions of issues, while the stock market only has thousands of issues. Again, this goes back to the disadvantages of ETFs we discussed before - some ETFs are not widely traded and has poor benchmark trackings.

In our next blog post, we will discuss how do you choose among different ETFs.

ETFs vs Index Mutual Funds: Pros and Cons - Part II

4/23/2015

In last blog post, we discussed 3 major advantages of ETFs. Now we will discuss some disadvantages of ETFs.

1. Bid-ask Spreads
The demand and supply for ETF do not always match, which means there is a difference between the buy and sell prices - called bid-ask spread. When the bid-ask spread widens, the price you paid for an ETF could be at a premium to its underlying asset value - Net Asset Value.

This is especially a problem for ETFs with small trading volumes.

You can look up an ETF's bid-ask spread, along with the premium or discount to NAV at ETF.com. Just search the ETF, then click the Tradability tab, you will find the ETF's average spread and NAV.

2. Trading Costs
Most of they times, you will have to pay trading commissions when you buy or sell an ETF. Depending on which brokerage firm you use, how frequently you trade, and how much is your investment amount, this cost could add up and become significant.

This is especially a problem for investors using dollar-cost averaging method by investing money regularly to an ETF.

A solution is to find a broker that does not charge commissions for certain ETFs. Most big brokers offer some commission-free ETFs.

ETF vs. Index Mutual Funds: Pros and Cons

4/22/2015

Q. What are the advantages and disadvantages of buying ETFs vs. Index Mutual Funds?

A. First, let's discuss three major advantages of ETFs over Mutual Funds.

1. Low Costs for ETFs
We have discussed before that ETFs have inherent low cost structure. Based on Morningstar results, the average expense ratio for an ETF that tracks a broad mix of U.S. stocks is 0.38%, that ratio is 0.45% for no-load index mutual funds. If you add broker-sold index funds that charge commissions and the average expense ratio jumps to 0.73%, almost double that of ETFs.

If you run our Fund Expense Impact on Profit tool, you see appreciate why low expense is such a big deal, especially for long term investors.

2. Tax Efficiency for ETFs
When a fund managers make trades, most exchange-traded products have to distribute net realized capital gains to shareholders. Compared with other mutual funds, Index Mutual Funds make fewer trades because they are passively managed, but ETFs go one step further - they don't always have to sell holdings when an investor cashes out.

Of course, if you are investing in a tax-efficient account such as IRA, the above difference doesn't matter.

3. Flexibility for ETFs
You can always buy and sell ETF anytime at market price, or at limit price (it might not go through, though), For mutual fund investors, they have to wait till the market closes in order to find out how much they are buying or selling their funds.

Furthermore, you can buy as little as one share of an ETF, many mutual funds have minimum investment requirements.

In next blog post, we will discuss the major disadvantages of ETFs.

Why ETFs Can Keep Costs Low When Compared With Mutual Funds?

4/22/2015

Q. Why ETFs can keep costs low compared with mutual funds?

A. When we say a fund is expensive or not, we usually refers to the fund's expense ratio. While ETFs are not always the cheapest option, their structure keeps costs low.

When you invest in a mutual fund, the manager has to buy securities with your cash, as well as keep records, etc. all of which have costs.

With ETFs, you buy existing shares that an institutional investor has already created, minimizing transaction costs, since no one at the ETF has to register your order.

When demand and supply of an ETF do not match, the ETF's price could deviate from its Net Asset Value, someone could view this as an disadvantage of ETFs.

Should I Hold or Sell ESPP Stocks?

4/21/2015

Q. I participated my company's ESPP, should I sell the stocks right away?

A. Unless you are determined to hold the ESPP stocks for more than a year, the best strategy is to sell right away.

Benefits of ESPP
If your ESPP qualifies for special tax treatment under IRC Section 423, you do not recognize income on the discount (which can be up to 15%) at the time of purchase. Section 423 limits annual purchases to $25,000, based on the stock value at the start of the offering period. Only a small percentage of employees can buy that much, because the plans generally limit purchases to 10% of an employee's compensation.

The most attractive ESPPs have discounts off the purchase price and lookback provisions that base the purchase price discount on the lower of the stock's prices at either the beginning of the offering period (looking back) or the purchase date. If the stock's price increases during this time, the discount can effectively be more than 15%.

Risks of ESPP
Like any stock purchase, holding stock bought through an ESPP entails some risk.

As with any stock, the price can fall.
Buying and holding stock reduces available cash, and the funding is deducted from your paycheck.
During the offering period, the deductions accumulated for the purchase do not earn interest.

Hold or Sell ESPP Stocks?
Most corporations allow ESPP participants to immediately sell their shares to realize a quick gain equal to the discount, minus any taxes and brokerage commission on the sale.Accumulating stock of a single corporation can create a portfolio that is less diversified than desirable. The rule of thumb is that your company's stock should make up not more than 10% of your portfolio's total assets.

Generally, it's the best strategy to sell the ESPP stocks right away. Because if you hold the ESPP stocks for less than year, any time you sell during this period, your gain at the sale date will be taxed at the ordinary income tax rate instead of at the much lower long-term capital gains rate if you hold the ESPP stocks for more than a year. However, holding the ESPP stocks for more than a year has major risks - what if stock price falls after 12 months?

The Best Cash Back Credit Card

4/20/2015

Q. What is the best cash back credit card that does not use the rotating categories?

A. The Citi Double Cash Card is probably the best cash back credit card that doesn't use the rotating categories (other than Fidelity Amex card that also offers 2% back on anything you purchase, but you have to be a Fidelity customer and Amex card is not widely accepted).

The Citi Double Cash Card includes the following features:

Earn 1% cash back on every dollar you spend
Earn an additional 1% back for every dollar you pay off
No annual fee
No limit on the rewards you can earn
You can start redeeming with as little as $25 in rewards
Redeem for a statement credit, gift card or a check
0% APR on purchases and balance transfers for the first 15 months
Comes chip-enabled, so you’ll be ready for the U.S. transition to EMV

The only drawback of this Citi Double Cash card? Its foreign transaction fee is 3%, so never carry this card when you travel abroad!

How to Balance Emergency Fund and 401K Saving Goals?

4/19/2015

Q. I just started working last year. How to balance the two goals - save for emergency fund and save for 401(k)?

A. The conventional wisdom is to save an emergency fund that could cover at least 3-6 months' living expenses. Until you hit that goal, investing should not be your top priority, but it is important to save enough to your 401(k) so you can get the employer's match.

To balance the two goals, hold some less risky assets in your 401(k) so if you are forced to cash out a 401(k) as a last resort, you have some safe money there to do it.

How to Determine Rent or Buy?

4/18/2015

Q. Should I rent or buy a house?

A. There is a rule of thumb - rent if you might move in 3 years or so, because don't forget all the fees, commissions, and closing costs that come with buying a property.

Local real estate pricing levels and trends also matter, as well as your tax bracket.

You can use the Rent/Buy Calculator at Trulia.com to see the graphical comparison results.

Finally, a old rule of thumb - your housing cost should be no more than 28% of your gross monthly income, housing plus other debt, 36% or less.

How to Check the Background of a Financial Professional Easily?

4/17/2015

Q. I have been courted by someone who offers superior financial products. What's an easy way to check his background?

A. Many savvy investors think fraudsters mostly target novices, but below is a typical financial fraud victim:

Married male
Age 50-65
College educated
Having nest eggs
Financially literate
Open to high risk investments
Belongs to religious or professional groups
Experienced recent change in financial or health status

There is an easy way to check the credentials and track record of a financial professional before you investing with them - visit SmartCheck.gov, it has free tools making your background check easy.

Roth 401K Common Questions

4/16/2015

What is Roth 401(k)?
A Roth 401(k) combines features of the traditional 401(k) with those of the Roth IRA. It’s offered by employers like a regular 401(k) plan, but as with a Roth IRA, contributions are made with after-tax dollars. While you don’t get an upfront tax-deduction, the account grows tax-free, and withdrawals taken during retirement aren’t subject to federal income tax, provided you’re at least 59 1/2 and you’ve held the account for more than five years.

Who is eligible for a Roth 401(k)?
Anyone whose employer offers it.

Why should I consider Roth 401(k)?
The Roth 401(k) can offer advantages to high-income individuals who haven’t been able to contribute to a Roth IRA because of the income restrictions. (Roth IRA eligibility for 2015 contributions phases out between adjusted gross income of $116,000 and $131,000 for single filers and $183,000 to $193,000 for those who are married and file jointly). There are no such income restrictions for Roth 401(k)s.

In addition, Roth 401(k) accounts are subject to the same contribution limits as a regular 401(k) — a maximum of $18,000 for 2015, or $24,000 for those 50 or older by the end of the year, this is much higher than the 2015 Roth IRA contribution limit of $5,500 a year, or $6,500 for those 50 or older.

Should I consider Roth 401(k) or Regular 401(k)?
The 401(k) contribution limits apply to all types of 401(k) plans, be it a regular 401(k) or a Roth 401(k). So you face a difficult choice: contribute to a Roth 401(k) and suffer a cut in take-home pay (since contributions are made with after-tax dollars), or stick with a traditional 401(k) and hope that in retirement tax rate will be lower than it is now. Alternatively, you could hedge your bets by contributing to both types of accounts.

Ultimately, making a sound decision largely hinges on your estimation of the tax rates you’ll pay during your retirement years. If you expect your tax rate to be the same or higher in retirement than it is now, you might be better off with a Roth 401(k). For folks who are in the 15% or 25% tax bracket, it may not be a bad idea to pay those taxes now and never have to worry about what tax brackets might become in the future. On the other hand, if you’re in your peak earning years and you figure your tax bracket will be lower in retirement, you’ll benefit from continuing with traditional 401(k) contributions.

In reality, of course, things are much more complicated. For one, no one can predict with certainty what tax rates will be in the future, though the general consensus is that they’re likely to rise to help the government offset budget deficits and pay for Social Security and Medicare.

What happens to the employer match?
Employer matches are made with pretax dollars, and the match accumulates in a separate account that is taxed as ordinary income at withdrawal.

What are the early withdrawal rules?
Early Roth 401(k) withdrawal rules are subject to the same requirements as traditional 401(k)s, according to the IRS.

What happens if I leave my job?
The Roth 401(k) balance can be rolled over into a Roth IRA.

Is the Roth 401(k) option here to stay?
Yes. At one time, the Roth 401(k) option was temporary, but it was made permanent by 2006 legislation. So this is a deal you can count on.

5 Tips For Secure Emails

4/16/2015

Cyber risk may cost you not just time and lost productivity, but also real money if fall into a victim of phishing scams. Below are 5 tips to create secure emails:

1. Create a private primary email address
This is your main email address and only for the trusted parties. Never use it to subscribe anything, mark any junk email you receive to this address as junk.
.
2. Read emails as plain text
If you select "view as plain text", all of the bad links, embedded viruses and other malware go away. Yes, you lose all of the graphics and links, but you lose the threats as well.

3. Use an email forwarder
Leemail.me is a great email forwarder, you can use it to auto-generate an address whenever you need to share your email with an unfamiliar company or a newsletter. It will forward the email from that company to you and you can always shut off that sender when you no longer wish to receive emails from it.

4. Don't hit "unsubscribe"
If you do, you will just verify that your email address is legitimate. Instead, call that company's customer service and ask them to remove your email or domain "blacklisted". If they refuse, report it to FTC.

5. Create secure passwords
Never use the same password for everything! Never use your birthdays or your kids' names or just "password" as passwords. Instead, create a spreadsheet of your passwords and save it in a secure place, of course, on the spreadsheet, only write things that you can understand so in case it falls to the other people's hands they can't decipher it.

What Is NUA Strategy?

4/15/2015

Q. What is NUA strategy?

A. NUA strategy refers to a special case in 401k rollover to IRA - if someone holds employer stock in his or her 401k account and that stock may present an opportunity to use the Net Unrealized Appreciation (NUA) calculation (the difference between the stock's current market value and the value when it was allocated to the account) to save on tax.

For example
Aretiree at age 65 with a $500,000 lump sum distribution that includes $200,000 (current value) of employer stock. The stock was worth $75,000 when it was allocated to my account. If she rolls the entire amount into an IRA, all future distributions will be taxed at the applicable ordinary income rate.

In an NUA strategy, she would roll the $300,000 to an IRA but take the employer shares as a distribution. The $75,000 will be taxed as ordinary income, but the remaining $125,000 will be taxed at long-term capital gains rates when she sells. The rates-differential could result in substantial tax savings so it makes sense to consider NUA treatment when it’s available before rolling over the entire account.

NUA treatment is available only as part of a lump sum distribution paid within one taxable year and rolling over the stock to an IRA eliminates the NUA opportunity.

When to Change My Investment Strategy?

4/14/2015

Q. I plan to retire in 20 years. Currently all my investments are in stocks. When should I start adding non-stocks to my portfolio?

A. Generally, if your risk tolerance level is high, you can wait to consider changing your current investment strategy until you have about 10 years to retire.

Another sign that you should consider diversifying your current all stocks portfolio is, if your projected retirement income level will be high enough, you do not have to take too much risk anymore, you can start reducing your exposure to stocks.

By adding non-stocks to your investment portfolio, you might give up some upside, but it will do you well if a market crash like the 2008 crash ever happens again. Because if you keep all your investment in stocks, you might lose a substantial amount of money in a very short amount of time. Or worse, if you experience other disastrous events for job or family reasons, the situation will be exacerbated.

With a diversified portfolio, your hit will be much less severe in those situations, and even better, your can rebalance to profit from the market crash.

Can I Get Refund For My Over Payment of Social Security Tax If I Worked For Two Employers Last Year?

4/13/2015

Q. I worked for two employers last year and more than the maximum social security tax was paid on my wages, will I get refund for the overpayment?

A. Each employer is required to withhold the employee’s tax, and to pay the employer’s tax, on wages up to the maximum earnings base for the year. Consequently, if someone works for more than one employer during the year, the taxes paid may exceed the maximum payable for the year.

In this case, you are entitled to a refund of your overpayment, or the overpayment will be credited to your income tax for the year.

Your employers, however, are not entitled to any refund or credit.

Kiddie Tax - How to Avoid It?

4/12/2015

In our last blog post, we discussed who needs to report kiddie tax - the parent or the child.

Now the most important question - how to avoid kiddie tax?

The best way is to maximize the usage of the $2,000 threshold each year!

This means taking capital gains each year by selling stocks with smaller gains each year and then buying the stock back, creating a taxable event each year. The transaction also allows the cost basis on the investment to increase while using up some or all of the yearly $2,000 threshold.

5 Strategies to Withdraw Retirement Funds Penalty Free Before 59

4/12/2015

Q. I plan to retire before age 59, how can I take my retirement money penalty free?

A. Here are 5 strategies you can consider so you can take your retirement money penalty-free before the age 59:

Participate Substantially Equal Periodic Payment (SEPP) Program
IRS offers the SEPP program that allows you to withdraw funds from your pre-tax IRA and 401(k) accounts before you turn 59½ penalty-free. A SEPP program can be started for an IRA at any time, as long as you keep it going for at least five years or until you are 59½, whichever is longer. You still have to pay income taxes, but the withdrawal is not subject to the early withdrawal penalty.

Take Early 401(k) withdrawals if you retire at 55 or later
If you leave your job after age 55, it doesn't matter whether you quit, retire, or are fired, you can withdraw penalty-free money from your 401(k). However, you cannot take penalty-free early withdrawals from previous employers if you left that company before you turned 55. The workaround is to move the money into your current employer's 401(k) before you quit if you need access to the funds early.

Withdraw money from a Roth IRA
While the best strategy is to delay Roth IRA withdrawals as long as possible because the money can generally be withdrawn tax free in retirement, but you can access contributions to your Roth IRA at any time. However, the portion of your Roth IRA balance that comes from earnings will need to stay in the Roth IRA until you are 59 1/2 if you want to avoid penalties.

Do a Roth conversion and then wait five years
Convert your pre-tax funds to a Roth and then wait five years, you can then take money out penalty-free. You'll need to calculate the numbers to make sure a Roth conversion is best for your tax situation, which typically is the year you don't have regular taxable income..

Use a taxable investment account
If your goal is to retire long before your 60s, you'll probably need to do some of your saving and investing in a taxable investment account. This money can be withdrawn and spent at any age without penalty. Just make sure you take into account that you may need to pay capital gains taxes on your gains when you sell your investments.

Kiddie Tax - Who Reports It - The Parent or the Child?

4/11/2015

In our last blog post, we discussed how does kiddie tax work. Now the key question - who reports the kiddie tax?

The Kiddie Tax can be reported on the either the parent's (using Form 8615) or child's tax return.

Usually, the best way to handle the Kiddie Tax is for the child to file their own tax return, as including the child's income on the parents return has other requirements.

These requirements must be met to include a child's income on the parents' tax return:

Form 8814 must be used.
The child was under age 19 (or under age 24 if a full-time student) at the end of 2014.
The child’s only income was from interest and dividends, including capital gain distributions and Alaska Permanent Fund dividends.
The child’s gross income for 2014 was less than $10,000.
The child is required to file a 2014 return.
The child does not file a married filing jointly (MFJ) tax return for 2014.
There were no estimated tax payments for the child for 2014 (including any overpayment of tax from his or her 2013 return applied to 2014 estimated tax).
There was no federal income tax withheld from the child’s income.

If these requirements do not matter, it may not make a difference whether the child files their own tax return or not.

However, there are circumstances when you want to have the child file their own tax return. One example is when a child’s income is added to the parents’ tax return, the additional income can cause unwanted tax effects.

In our next blog post, we will discuss the strategies to avoid kiddie tax.

Kiddie Tax - How Does Kiddie Tax Work

4/10/2015

In our last blog post, we discussed some exceptions on kiddie tax reporting. If your child does face kiddie tax, how does it work? We will use 2014 as the example year to discuss.

Generally, the Kiddie Tax applies the parents’ highest tax rate to any unearned income of the child that is greater than $2,000 for 2014.

A child can have unlimited earned income from work without worrying about the Kiddie Tax. Earned income of a child (from working a summer job for example) is not subject to the Kiddie Tax.

However, unearned income greater than the income limit will be taxed at the parent’s tax rate if the child falls under the Kiddie Tax rules. Of the unearned income, the amount under the income limit is taxed at the child’s rate and the excess gets taxed at the parents’ highest rate.

The age rules for the Kiddie Tax can be a bit confusing. The Kiddie Tax applies:

Until the year the child turns 18 regardless of earned income.
In the year the child turns 18 unless the child's earned income is more than half his or her overall support.
In the years your child turns 19 through the year your child turns 23, if the child is a full-time student during any part of at least five months during the year unless the child's earned income is more than half his or her overall support.

In our next blog post, we will discuss who reports kiddie tax on the tax return.