The Kiddie Tax is a provision designed to prevent parents from shifting investment income to their children to take advantage of their lower tax rates. This tax applies when children receive substantial income from investments like dividends, interest, and capital gains. If certain thresholds are met, the child's unearned income will be taxed at the parent's tax rate instead of the child's lower rate.
Here’s a breakdown of how the Kiddie Tax works, who it applies to, and how to report the income.
1. What Is the Kiddie Tax?
The Kiddie Tax refers to a set of tax rules that apply to children under the age of 19 (or under 24 if they are full-time students) who have unearned income, such as investment income, above a certain threshold. The goal is to prevent parents from transferring assets to their children to exploit the lower tax brackets available to minors.
2. Who Is Affected by the Kiddie Tax?
The Kiddie Tax applies to children who meet all of the following criteria:
Age Requirement: The child must be under age 19, or under age 24 if a full-time student.
Unearned Income: The child must have unearned income that exceeds a specific threshold. Unearned income includes:
Interest from savings or bonds.
Dividends from stocks.
Capital gains from the sale of assets.
Rental income or other passive income.
Parent's Income: The Kiddie Tax applies when the child's unearned income exceeds a set amount (see the income threshold below).
3. How the Kiddie Tax Works
Under the Kiddie Tax rules, children who have unearned income above a certain threshold will be taxed at the parent’s tax rate rather than at the child's tax rate.
A. Income Thresholds for Kiddie Tax
For tax year 2024, the Kiddie Tax kicks in if the child’s unearned income exceeds $2,300. Here's how it breaks down:
First $2,300: The first $2,300 of the child’s unearned income is taxed at the child's tax rate (typically the 0% or 10% rate, depending on total income).
Next $1,150: The next $1,150 is taxed at the child’s tax rate (likely the 10% rate).
Income Over $3,450: Any unearned income above $3,450 is taxed at the parents' tax rate, which can be much higher. This is the point where the Kiddie Tax starts to affect the child's overall tax rate.
B. How Investment Income Is Taxed
Interest, Dividends, and Capital Gains: If the child earns interest, dividends, or capital gains from investments, this income is subject to the Kiddie Tax if it exceeds the threshold.
Interest and Dividends: These are generally taxed at the child’s ordinary income tax rate unless the income qualifies for a 0% tax rate (for lower income children).
Capital Gains: The sale of investments, such as stocks or mutual funds, results in capital gains, which are also subject to the Kiddie Tax rules.
4. How the Kiddie Tax Affects Filing
To report unearned income and the Kiddie Tax, the child must file their own tax return, even if their total income is below the standard filing threshold.
A. Filing Requirements for Children
Unearned Income Above $1,150: If a child’s unearned income exceeds $1,150, they must file a tax return.
Tax Forms for Children: The child will need to complete Form 8615, Tax for Children Under Age 19 (or 24 if a student), to calculate the Kiddie Tax.
B. Who Files the Return?
Parents may elect to include the child’s income on their tax return if the child is under 19 or 24 (if a full-time student), but this is optional. However, if the child has more than $1,100 in unearned income, the parents cannot file the child’s income on their return, and the child will need to file their own return.
5. Impact of the Kiddie Tax on Tax Brackets
The Kiddie Tax means that children with significant investment income may face a higher tax rate than the standard rates that would otherwise apply to their income. Since the unearned income is taxed at the parents' higher tax rate (in the case of the Kiddie Tax), this can lead to a larger tax liability.
For example:
A child with $5,000 in unearned income will have the first $2,300 taxed at the child's rate (typically 0% or 10%), and the remaining $2,700 will be taxed at the parents' tax rate.
6. Exceptions to the Kiddie Tax
While the Kiddie Tax applies to children under 19 (or under 24 if they are full-time students), there are some exceptions to the general rule:
A. Married Children
If the child is married and files jointly with their spouse, the Kiddie Tax does not apply, even if the child’s unearned income exceeds the threshold.
B. Certain Types of Income
Income from a business: If a child has income from self-employment or a family business, this income is not subject to the Kiddie Tax.
Tax-Free Investment Income: Certain types of tax-exempt income, such as income from municipal bonds, may not be subject to the Kiddie Tax.
7. Strategies to Minimize the Kiddie Tax
There are several ways that families can reduce the impact of the Kiddie Tax:
A. Spread the Investment Income
If the child has a substantial amount of investment income, splitting the income between family members may help lower the tax burden. For example, if parents or other family members hold some of the child’s assets, the Kiddie Tax will not apply to the income they generate.
B. Gift Investments to the Child
Gifting assets to children can help distribute investment income, but if the child is subject to the Kiddie Tax, the income will still be taxed at the parents' rate above the threshold.
C. Use Tax-Advantaged Accounts
Contributing to 529 college savings plans or custodial accounts (such as UGMA/UTMA accounts) may help shelter investment income from taxes, as some of this income can be deferred or taxed at the child’s lower rates.
D. Taxable vs. Tax-Exempt Investments
Invest in tax-exempt bonds or other tax-deferred investments, which generate income that may not be subject to the Kiddie Tax.
8. Key Takeaways
The Kiddie Tax ensures that children with substantial unearned income pay taxes on that income at the parents' tax rate. This tax applies to children under 19 (or under 24 if a full-time student) who have investment income exceeding a certain threshold. Here are the key points to remember:
The Kiddie Tax applies to unequal income (such as interest, dividends, and capital gains) earned by children under 19 (or under 24 if a student).
The first $2,300 of unearned income is taxed at the child’s rate, but any income above this amount is taxed at the parents' tax rate.
To file the tax, children may need to complete Form 8615.
Parents should be aware of the filing requirements and how the Kiddie Tax could affect their child’s overall tax liability.
By understanding the Kiddie Tax rules, families can better plan and manage their investment strategies to minimize the potential tax impact on their children’s income.