The Kiddie Tax - Explained

Understanding the complexities of taxation presents challenges for individuals across the board. Families with children encounter additional nuances in tax planning. Among these considerations is the IRS Kiddie Tax, a framework designed to tax the unearned income of specific children at their parents’ tax rate. Grasping the workings of the Kiddie Tax is essential for parents to navigate their tax obligations efficiently. Let’s explore the details of the Kiddie Tax and its potential impact on your family’s tax circumstances.

What is the Kiddie Tax?

The Kiddie Tax is a tax provision implemented by the IRS to prevent parents from transferring investment income to their children to exploit their lower tax rates. It primarily targets children who earn unearned income surpassing a specific threshold. This provision applies to children under 19 years old or under 24 if they are full-time students. Unearned income encompasses various sources such as interest, dividends, capital gains, rents, and royalties, alongside taxable scholarships and income generated from familial gifts.

Exemptions

Certain exemptions exist from the Kiddie Tax regulations, meaning not all children are subject to its provisions. A child will be exempt from the Kiddie Tax rules if they meet any of the following criteria:

The child has no surviving parents by the end of the tax year.
The child is married and has filed a joint tax return for the tax year.
The child isn’t obligated to file a tax return for the tax year.
The child is completely or permanently disabled.
The child is emancipated.

How does it work?

The Kiddie Tax operates as follows: The initial $1,250 of a child’s unearned income remains untaxed. Subsequently, the subsequent $1,250 is subjected to the child’s tax rate of 10%. Furthermore, any income surpassing $2,500 is taxed at the higher of either the child’s tax rate or the tax rate of the parent or guardian. For instance, if a child’s unearned income amounts to $3,000, $500 would be subject to the Kiddie Tax. Notably, the threshold will increase to $2,600 for the tax year 2024.

In 2023, a child’s standard deduction is determined by the greater of $1,250 or the child’s earned income plus $400, provided they can be claimed as a dependent. This is because $1,250 serves as the standard deduction for dependents. In cases where the child cannot be claimed as a dependent, they typically utilize the standard deduction of a single filer, which amounts to $13,850 for the year 2023.

Examples

Here are some examples illustrating the application of the Kiddie Tax:

Sarah receives $3,000 in dividend income from stocks held in a custodial account under her name. Given her parents’ marginal tax rate of 24%, under the Kiddie Tax rules, the portion of Sarah’s income exceeding the $2,500 threshold ($500) will be taxed at her parents’ tax rate.
Let’s consider a family with two children, Jack and Jill. Jack, aged 17, earns $1,800 in interest income from savings bonds. Jill, aged 20, is a full-time college student who receives $3,500 in dividends from investments. Jack’s income will be taxed at his individual tax rate of 10%. However, Jill’s income will be subject to the Kiddie Tax, taxed at her parents’ tax rates.
17-year-old Mike is legally emancipated from his parents. He earns $5,000 in interest income from a savings account in his name. As the Kiddie Tax does not apply to emancipated individuals like Mike, his interest income will be taxed at his individual tax rate.
Ana, aged 18, has a disability that meets certain IRS criteria. Despite her disability, Sarah receives $4,000 in dividends from investments. If Ana’s disability qualifies her for an exemption from the Kiddie Tax, her dividends may be taxed at her individual tax rate rather than the trust and estate tax rates.

Reporting the Kiddie Tax

Reporting the Kiddie Tax on your tax return involves several steps to ensure accurate compliance with IRS regulations. Here’s how to report it:

Calculate the child’s unearned income for the tax year. This includes interest, dividends, capital gains, rents, royalties, and other passive income sources.
If the child’s unearned income exceeds the threshold, apply the Kiddie Tax rates to the portion of income exceeding the threshold. For 2023, unearned income up to $2,500 is taxed at the child’s rate, while any amount over $2,500 is taxed at the parent or guardian’s tax rate, which can be significantly higher.
If the Kiddie Tax applies, use IRS Form 8615, Tax for Certain Children Who Have Unearned Income. This form assists in determining the portion of the child’s unearned income subject to the Kiddie Tax and calculates the tax liability at the appropriate rate. Parents should attach this form to the child’s Form 1040. Alternatively, in some cases, parents can include the child’s income on their own return using Form 8814, Parent’s Election to Report Child’s Interest and Dividends.

Tax Help for everyone

For parents incorporating financial planning strategies involving their children’s investments, comprehending the Kiddie Tax is paramount. Although aimed at preventing tax evasion, its implications can greatly influence investment decisions’ tax aspects. Seeking advice from a tax advisor or financial planner is advisable to devise tax-efficient strategies coherent with overall financial objectives.

Disclaimer: This is not legal advice, consult an attorney for legal advice or contact us.

The Kiddie Tax – Explained