It’s important to consider the potential tax consequences of your investment decisions.
But what about your children? What kinds of investment options are available to them — and how are they taxed?
Oddly enough, I was considering this very question recently after my 10-month-old daughter was baptized last December. She received some very generous gifts of money from our families and friends.
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I’m a financial adviser by trade. So, I couldn’t help but ask myself: How should I invest this money on her behalf?
We’ve already established a 529 college savings plan for her.
But my wife and I agree that the money she was given at her baptism is her money. She should have the freedom to use it as she wants to. When she’s an adult, of course.
Unfortunately, she can’t open an investment account for herself. But we can open one on her behalf: either a Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) account.
The UTMA/UGMA alternative
These taxable investment accounts allow a custodian (meaning my wife or me) to manage investments for a minor (meaning our daughter) until she reaches the age of majority. In Massachusetts, where we live, that age is 21. In other states, it may be 18.
After comparing these options, we’ve decided to open a UTMA, although the tax-planning strategies I’ll be discussing apply to UGMAs as well.
Once she reaches 21, the UTMA will be re-registered as a brokerage account in her name, and she’ll be given full ownership. That means she can spend it on anything she wants (we’ll worry about that later).
The tax factor
To maximize the growth of the gift our daughter will ultimately receive when she gains access to her UTMA account, we want to be smart about how we manage it for her. One important way to do that is by minimizing the taxes that must be paid on it over time, including the dreaded “kiddie tax.”
Fortunately, for 2025, the IRS exempts the first $1,350 of a child’s unearned income, the same amount as their standard deduction. (Unearned income is income you earn through means other than work, including investment income and capital gains.)
The next $1,350 of unearned income is then taxed at the child’s rate, which will most likely be 10%. Parents generally report this income on their own tax returns.
Any amount of unearned income above $2,700 is taxed at the parents’ marginal tax rate. This is known as the dreaded “kiddie tax.”
A kiddie-tax planning strategy
Naturally, we’d like to keep our “kiddie tax” burden as low as possible. So, we’ve come up with a way to use that initial $1,350 exclusion as a tax-management tool. How? By executing strategic sales of investments in her UTMA account over the years to effectively raise the cost basis of her funds and reduce the amount of taxable gains she will incur when she takes over the account
Let’s suppose that a year from now, the value of the mutual funds in my daughter’s UTMA grows. I could sell shares of certain funds and realize gains of up to $1,350 without generating any taxes.
Once I receive the proceeds, I can reinvest the money into the same funds. Since I — I mean, our daughter — profited from the sale, the IRS wash sale rules don’t apply.
Doing this increases the overall cost basis of those shares. Since I’m now repurchasing them at a higher price, the realized gains will be less if I sell them again in 2027 than if I sold those same shares after letting them sit for a few years. This will enable me to gradually “step up” the cost basis of more and more shares over time.
Let’s illustrate how this could work, using two different very simplified scenarios.
(Note: These are for illustrative purposes only. I would never invest all of anyone’s money in a single fund.)
Method one: Buy now, sell every year
On January 2, 2025, I invest $10,000 in our daughter’s UTMA to buy 100 shares of ABC S&P 500 index fund trading at $100 a share.
On January 5, 2026, I sell 67 shares at $120 a share, for a total of $8,040. Since the cost basis of these shares was $6,700 (67 x $100), I end up with a net gain of $1,340. This entire gain is exempt from taxes. (Note: I wait a year so this profit can be characterized as a long-term capital gain.)
Two days after that trade settles, I reinvest most of the $8,040 to buy 65 shares of the same fund at $121 a share. (It went up a little after I sold it. Oh well.)
Flash-forward to 2027. The share price has risen to $128. If I sell these 65 “stepped-up cost-basis” shares for $8,320, my total net gain for this sale would be $455. ($8,320 [65 X $128] – $7,865 [65 x 121]).
Assuming I wanted to realize an additional $840 in gains to reach close to the full $1,350 non-taxable amount, I could sell an additional 30 shares using their original $100 cost basis ($3,840 [30 X 128] – $3,000 [30 X 100] = $840).
If the share price stayed the same when I repurchased shares a few days later, I would now have a higher cost basis for 95 of my original 100 shares.
Method two: Sit and sell two years later
After buying my 100 shares for $10,000 in 2025, I wait until January 5, 2027, to try to realize close to $1,350 in non-taxable realized gains. Using my original cost basis, I could sell “only” 47 shares at $128 a share ($6,016 [47 x $128] – $4,700 (47 x $100) = $1,316).
In both scenarios, I end up with close to $1,350 in non-taxable gains with each sale. However, using the first method, I end up with 48 more shares with a stepped-up cost basis. Using this same strategy every year makes it easier to continue increasing the cost basis of these shares over the years while skirting investment taxes at the same time.
Of course, this process isn’t as simple as it sounds
If you want to execute this strategy using mutual funds, you need to tell the mutual fund company that you want to sell the “stepped-up” shares first.
Also keep in mind that some mutual funds may also generate capital gains and ordinary income on their own that could push you past the $1,350 “untaxable” limit in a given year.
And you’ll need to keep detailed records of every one of these sales for years, in case the IRS ever audits you.
In the end, it’s all for our daughter’s benefit, really
OK, this strategy may sound like one that “Dad” uses to avoid paying taxes on investment gains — or, at least, minimizing them.
But in the end, our daughter will be the one who benefits most when it’s time for her to take control of her UTMA. Arguably, she’ll be better off financially if she doesn’t have to pay a boatload of taxes when she starts selling shares of funds that have appreciated significantly over the decades since they were purchased.
And, if by using this cost-basis step-up strategy I can help her (well, me, really) avoid paying taxes on a portion of gains along the way, what’s wrong with that?
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
