Who pays grandkids’ taxes on dividends?

Dear Tax Talk,
If I open a stock account for my grandchildren, and they collect dividends but have them reinvested, I know a Form 1099 would be in their name. But taxes would have to be paid on dividends no matter what. So my question is: How and who would pay the taxes on dividends if the kids are from 1 year to 5 years old? I would be custodian on the accounts. Or would it be better for the parents to be custodians, and if they are, then would I have control of the account? Thank you.
— Bob

Dear Bob,
It used to be so easy to transfer some assets to your grandkids and shift the tax burden to them as well. Over the years, the benefit of income shifting has diminished. However, it is still a great way to establish savings for your grandchildren and also get appreciating assets out of your estate. Since minors are not allowed to contract, the conveyance of property is done through the Uniform Gift to Minors Act, or UGMA. An UGMA custodian account is established with a broker or bank to invest in the assets the custodian chooses.

Current income on an UGMA is taxed to the minors. The parent or other guardian of a child with taxable income is required to file and pay the tax the child owes. The first $950 in unearned income is exempt as the child is allowed a standard deduction of that amount while claimed as a dependent of another. The next $950 in unearned income is taxed at the child’s tax rate. A “kiddie tax” applies to any unearned income in excess of $1,900. The kiddie tax treats the unearned income in excess of $1,900 during the year as earned by the parents. This means the child’s unearned income in excess of $1,900 is taxed at the marginal tax rate of the parents. However, since the maximum tax rate on dividends is 20 percent, this may have little significance.

If the dividends are reinvested, someone else will have to pay out of pocket for any taxes on dividends owed. Use Form 8615 to compute the kiddie tax when unearned income exceeds $1,900.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

Bankrate’s content, including the guidance of its advice-and-expert columns and this website, is intended only to assist you with financial decisions. The content is broad in scope and does not consider your personal financial situation. Bankrate recommends that you seek the advice of advisers who are fully aware of your individual circumstances before making any final decisions or implementing any financial strategy. Please remember that your use of this website is governed by Bankrate’s Terms of Use.