Parents who invest money for their children may be surprised to learn that certain unearned income generated by those investments could be subject to a special tax rule known as the Kiddie Tax. Designed to prevent families from shifting investment income to their children to benefit from lower tax rates, the Kiddie Tax applies to minors and full-time students under a specific age threshold. Understanding how the Kiddie Tax works is essential for financial planning, especially for families who want to gift investments or set up custodial accounts for their children.
Definition of the Kiddie Tax
The Kiddie Tax is a federal tax law in the United States that applies to unearned income received by a child. Unearned income refers to money not earned from working, such as dividends, interest, capital gains, and other investment income. This tax rule ensures that children’s unearned income above a certain threshold is taxed at the parent’s higher tax rate, rather than at the typically lower rate that would apply to a child’s income.
Why It Exists
Before the Kiddie Tax was introduced, some families would shift income-generating assets to their children to take advantage of their lower tax brackets. The Kiddie Tax, first introduced in 1986 and later expanded, was created to eliminate this loophole and ensure a fairer tax system.
Who Is Subject to the Kiddie Tax?
The Kiddie Tax applies to children who meet the following criteria:
- The child is under age 18 at the end of the tax year.
- The child is age 18 and did not have earned income greater than half of their support.
- The child is a full-time student between the ages of 19 and 23 and also did not earn more than half of their support.
The child must also have unearned income exceeding a specified annual threshold, which is adjusted periodically for inflation. If the child’s unearned income is below this threshold, the Kiddie Tax does not apply.
Types of Unearned Income
The Kiddie Tax targets unearned income, which may include:
- Dividends from stocks
- Interest from savings accounts, CDs, or bonds
- Capital gains from the sale of assets
- Rental income
- Royalty payments
- Trust distributions
It does not apply to earned income from jobs, such as part-time work or internships, which is taxed according to the child’s individual tax rate.
How the Kiddie Tax Works
To determine how much tax a child owes under the Kiddie Tax, the IRS uses a multi-step approach:
- The first portion of unearned income (currently $1,300 as of recent tax years) is not taxed, due to the standard deduction for dependents.
- The next portion of income (another $1,300) is taxed at the child’s rate.
- Any unearned income above the combined threshold (typically $2,600) is taxed at the parent’s highest marginal tax rate.
This approach ensures that only a limited amount of a child’s investment income benefits from the lower tax rates generally applicable to children. The remainder is subject to higher taxation to align with the parent’s tax situation.
Filing Requirements and Form 8615
If a child’s unearned income exceeds the annual threshold, the IRS requires that they file their own tax return and complete Form 8615, Tax for Certain Children Who Have Unearned Income. This form calculates the portion of income that will be taxed at the parent’s rate.
Information Needed for Form 8615
To complete Form 8615 accurately, the following information is required:
- The child’s total unearned income
- The child’s taxable income
- The parent’s taxable income and filing status
Since the tax calculation relies on the parent’s income, cooperation between the parent and child is necessary when preparing their respective tax returns.
Strategies to Reduce or Avoid the Kiddie Tax
Families who want to minimize the impact of the Kiddie Tax can consider several tax-planning strategies:
Invest in Tax-Deferred Accounts
One way to reduce exposure to the Kiddie Tax is by investing in tax-deferred or tax-exempt accounts such as:
- 529 college savings plans
- Roth IRAs (for children with earned income)
- U.S. Savings Bonds that are tax-deferred until redemption
These types of accounts allow investments to grow without generating annual taxable income, thereby avoiding the Kiddie Tax altogether.
Use Growth-Focused Investments
Another option is to select investments that produce little or no current income, such as growth stocks that do not pay dividends. Capital gains are only taxed when the asset is sold, allowing families to delay tax liability.
Distribute Income Across Multiple Years
Spreading the sale of appreciated assets or distributions from a trust over multiple tax years can help keep annual unearned income below the Kiddie Tax threshold.
Impact on Trusts and Estate Planning
The Kiddie Tax is also relevant in the context of trusts and estate planning. If a child is a beneficiary of a trust that distributes income, the portion allocated to the child may be subject to the Kiddie Tax rules.
Trustees and estate planners often work to structure distributions in a tax-efficient way, balancing the goals of wealth transfer with the impact of additional taxation.
Historical Changes to the Kiddie Tax
The rules governing the Kiddie Tax have evolved over time:
- Originally introduced in 1986 to apply to children under 14 years old.
- Expanded in 2006 to include children up to age 18 and full-time students up to age 23.
- In 2017, the Tax Cuts and Jobs Act temporarily changed the tax rate structure, applying estate and trust tax brackets.
- In 2020, the SECURE Act reverted the tax rate back to the parent’s marginal rate, which is generally more favorable.
These changes reflect ongoing efforts to refine the tax code and ensure fairness in taxation of investment income.
Examples of the Kiddie Tax in Action
Consider the following example:
Emily is 17 years old and receives $5,000 in dividend and interest income from a custodial brokerage account. In 2024, the standard deduction for dependents is $1,300, and the next $1,300 is taxed at the child’s rate. The remaining $2,400 is taxed at her parents’ marginal tax rate of 24%.
Her tax liability would be calculated as follows:
- $0 on the first $1,300 (standard deduction)
- Taxed at child’s rate on the next $1,300
- Taxed at 24% on the remaining $2,400
This example illustrates how quickly a child’s investment income can be taxed at a higher rate under the Kiddie Tax rules.
The Kiddie Tax plays a significant role in the tax treatment of unearned income earned by children. It is designed to prevent income-shifting strategies while ensuring that investment income is taxed equitably. For families who invest on behalf of their children or plan to transfer wealth, understanding this tax rule is essential for effective tax planning. By using tax-deferred accounts, limiting current income, and staying within annual thresholds, parents can reduce the impact of the Kiddie Tax and help their children build wealth more efficiently.