Families of military service members who designated survivor benefits to a child have been surprised by higher tax liability due to changes in the kiddie tax. The benefits of a survivor annuity are often shifted to a child by a surviving spouse to avoid being eliminated by an ‘offset’ by service-related death benefits. Beginning in 2018, however, the unearned income of a child is taxed at the same rates that apply to trusts and estates. There are several proposals in Congress to address this issue.
Family members of deceased military service members (i.e., Gold Star families) are eligible to receive two different survivor benefits:
- Dependency and Indemnity Compensation (DIC) from the Department of Veterans Affairs (VA) for service-related deaths, and
- Survivor Benefit Plan (SBP) payments from the Department of Defense (DoD) under a member-purchased annuity.
Under current law, a family member of a deceased service member may not receive both benefits simultaneously. Instead, the SBP payment must be offset the amount of the DIC benefit received.
The offset is often referred to as the ‘widow’s tax’ as it reduces the SBP benefit on a dollar for dollar basis. The result is that a surviving spouse or other family member may receive only the DIC benefit from the VA as a result of service-related death as it tends to be higher.
The DIC benefit is currently less than $16,000 annually after the offset. Approximately 65,000 Gold Star families are subject to the widow’s tax according to the Tragedy Assistance Program for Survivors (TAPS), a non-profit that advocates for and provides support to military families. There is a partial reimbursement of the offset, known as the Special Survivor Indemnity Allowance (SSIA), but it is only $310 for 2018 and $319 for 2019.
To get around the offset, surviving spouses often put the SBP in the name of a child. This allows the spouse to receive the full amount of the DIC benefit. The child then receives the SBP benefit until turning age 18 or age 22 if a full-time student. The SBP is also terminated if the surviving spouse remarries.
A child’s unearned income is subject to the kiddie tax. Prior to the Tax Cuts and Jobs Act (TCJA), this meant that the child’s net unearned income was taxed at his or her parent’s marginal income tax rate. However, beginning in 2018 a child’s unearned income is taxed at the same income tax rate as for trusts and estates.
A child’s unearned income is generally all income other than salaries, wages, and other payments received for work. Examples of unearned income are interest, dividends, and annuity income. This means that the SBP benefits received by a child can be taxed at a rate as high as 37% as the threshold for trust and estate tax rates are much lower than for individuals.
For example, the 37% rate that applies to a trust or estate that has over $12,500 of taxable income in 2018. On the other hand, the lowest three income tax rates that apply to a single individual in 2018 are:
- 10% — taxable income of $9,525 or less
- 12% — taxable income over $9,525 and less than $38,700.
- 15% — taxable income over $38,700 and less than 82,500.
Many Gold Star families were unaware of the change in the tax law and could not plan accordingly. The result was much higher tax liability of children receiving SBP benefits in 2018 as compared to 2017.
The families were not the only ones who were surprised. Republican members of Congress who helped pass the TCJA have stated that this was an unintended consequence of the change in the kiddie tax rules. To resolve the issue, there are several bipartisan proposals in Congress that could help families out in the future.
One proposal would eliminate the offset between the VA’s DIC benefits and the DoD’s SBP benefits. Under the proposed legislation, the surviving spouse could then regain their eligibility to receive the SBP benefits simultaneously as the DIC benefits. However, the legislation would not affect the kiddie tax rules so the change in beneficiary would be necessary to avoid the increased tax liability for the child.
Another proposal would simply provide that any benefit a child receives from the VA and DoD would be treated as earned income for tax purposes. Thus, any SBP benefits received by a child would be taxed at the income tax rates for individuals using the lower taxable income thresholds.
Still other proposals would provide a broader fix to problems incurred with the new kiddie tax rules. These would address a similar problem for survivor benefits of first-responders, scholarship recipients, and Native Americans. There is no timetable when any of these legislative proposals will be enacted.
By John Buchanan, JD, LLM