What Is A Kiddie Tax? Definition, Overview, And How It Works

Prior to the Kiddie Tax, parents could save money on taxes by putting their children’s investment accounts in their names.

Parents would give their children stocks and other assets, and income received on the assets would be taxed at the child’s (lower) rate rather than the parent’s (higher) rate.

By taxing children’s passive income at higher rates, the Kiddie Tax addressed this loophole.

Do you have any income-generating assets in a custodial account for your children? If that’s the case, make sure you’re aware of the so-called “kiddie tax.”

What Is A Kiddie Tax?

The kiddie tax is a specific Internal Revenue Service (IRS) provision designed to discourage certain individuals from evading taxes by gifting their children’s investments.

They impose the kiddie tax on a child’s unearned income, which comes from sources other than work, such as interest and dividends. They define a kid as someone under the age of 18, or under the age of 24 if they are a full-time student, for ‌this tax.

Kiddie Tax Examples

Parents frequently invest money or buy stocks in their children’s names in order to save for their children’s education. This offers the advantage of putting the investments in the child’s name if the parents pass away.

When unearned income surpasses $2,100, parents might choose to file jointly or individually. Before deciding, compare the taxes due using IRS forms 8615 and 8814 to see which is the best option. Whatever method is used, the child always pays the tax.

History of The Kiddie Tax

They enacted the Kiddie Tax as part of the 1986 Tax Reform Act to prohibit parents from transferring income-producing assets to their children in order to benefit from the child’s lower tax rate. The Kiddie Tax applies to all unearned income beyond a particular level and taxes it at the parent’s marginal income tax rate rather than the child’s.

The Tax Cuts and Jobs Act of 2017 temporarily changed the laws, making the Kiddie Tax substantially more expensive for some families, by substituting the tax rates that apply to trusts and estates for the parent’s tax rate. Because of the impact on Gold Star families and scholarships, this sparked outrage.

In reaction to the backlash, Congress added a provision in the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) that allows the Kiddie Tax to be restored to its previous status retroactively.

For 2022, the first $1,150 of a child’s unearned income is taxed at the child’s marginal income tax rate, the following $1,150 is taxed at the child’s marginal income tax rate, and unearned income beyond $2,300 is taxed at the parent’s personal income tax rate. The thresholds for tax year 2021 are $1,100 and $2,200, respectively.

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How Does the Kiddie Tax Work?

They impose the Kiddie Tax on dependent children under the age of 19 or full-time students between the ages of 19 and 23. A child whose earned money covers more than half of their support costs is exempt from the Kiddie Tax.

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Another exception is for children who file joint returns with their parents. The Kiddie Tax does not apply to earnings from wages, salaries, tips, or self-employment.

Unearned income for a child could include: 

  • Interest that is taxable
  • Dividends 
  • Gains in capital 
  • Scholarships that are taxable 
  • Gifts from grandparents generate income.
  • Under the Uniform Gifts to Minors Act, income generated by custodial accounts is taxed (UGMA)

How Do You Calculate The Kiddie Tax?

To figure out the Kiddie Tax, start by calculating the child’s taxable income:

  • Child’s Taxable Income = 
  • Child’s Net Earned Income +
  • Also Child’s Net Unearned Income – 
  • Child’s Standard Deduction

The first $1,110 of unearned income generated by a kid is tax-free, with the remaining $1,110 subject to the child’s tax rate. Any earnings over $2,200 are taxed at the marginal tax rate of the child’s parents.

If a child can be claimed as a dependent in 2021, the standard deduction amount is greater of $1,100 or the sum of $350 plus the child’s earned income. Otherwise, a single filer’s standard deduction is $12,400.

If a dependent child has no earned income but has $3,500 in unearned income, $1,300 is liable to the Kiddie Tax and is taxed at their parents’ marginal federal income tax rate.

  • (Standard Deduction)–$0 (Earned Income) + $3,500 (Unearned Income) = $2,400 (Taxable income) $1,100
  • $2,200 (kiddie tax threshold) – $3,500 (unearned income) = $1,300 (Net Unearned Income)
  • $1,100 (Taxable Income – Net Unearned Income) = $2,400 (Taxable Income) (Earned Taxable Income)

What Are The Ways to Avoid Paying or Minimize the Kiddie Tax?

That the child tax exists does not imply that you or your family should pay it. You might ‌avoid it if you plan‌.

You should try to minimize the amount of tax you owe legally, as you should with all taxes.

However, this does not imply that you should engage in criminal behavior, such as failing to disclose income.

Thankfully, there are legal ways to avoid or minimize paying the child tax.

#1. Keep Investment Income Low for Children

Keeping investment and other unearned income for children minimal is the easiest approach to avoid the kiddie tax.

The following are the most typical types of unearned income: 

  • dividend income 
  • capital gains
  • interest income 

For investments for children, avoid those that provide interest or dividends. You don’t have any interest or dividend income to report if you don’t receive them.

After that, choose investments ‌you can hold for several decades. You risk the company going bankrupt if you gain individual stocks. When this occurs, you should often sell the stock to avoid losing money on your investments.

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Even if a company finally loses its path, you should be able to sell it for a substantial profit. A capital gain is a sort of unearned income that might be subject to the kiddie tax.

You can buy a mutual fund or an index fund instead of buying an individual stock that may or may not perform well for decades.

You can have a well-diversified investment that you may not need to sell for decades if you choose the correct mutual fund or index fund.

If your child is no longer subject to the kiddie tax regulations, they are free to sell these investments. Alternatively, they might invest the money to help them save for retirement.

#2. Use a 529 plan

Instead of giving your children investments to help them pay for college, consider a 529 plan.

When you contribute to a 529 plan, you won’t get a tax break.

For federal income tax purposes, however, include:

  •  Money taken out to pay for college is tax-free
  • Those wishing to save money for a future college education should, of course, seek advice from a professional, especially if they may be eligible for financial help
  • It can complicate financial aid algorithms
  • Investments maintained in a minor’s name and 529 plans can influence the amount of aid a child receives.

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#3. Use a Roth IRA

Because their parents give them investments, children rarely pay the kiddie tax.

A child who just wishes to invest can occasionally run into the kiddie tax on their own.

A child may be subject to the tax if they invest enough money and start earning enough interest or dividends on such investments.

They may also be affected if they make a wonderful investment and then sell it for a profit if the capital gains are significant enough.

If this describes your circumstance, have your youngster think about the type of account they’re using to invest.

A Roth IRA is one option that could be beneficial. It allows people to put their hard-earned money into a retirement account.

A tax deduction is not available when you donate to a Roth IRA.

The best part:

  • After attaining retirement age, money withdrawn from a Roth IRA is distributed without being taxed.
  • This type of account can be opened by a child who has earned enough money to contribute and meet the other requirements.
  • Interest, dividends, and capital gains can all be tax-deferred in this account.

The downside:

  • They cannot withdraw the money until the child reaches retirement age.

However, there are few exclusions that may allow you to take some money out early and avoid paying taxes and penalties. However, you must meet certain criteria in order to do so.
 

Are 529 Plan Earnings Subject To The Kiddie Tax?

What Is a 529 plan?

A 529 plan is a tax-advantaged investment vehicle in the United States meant to encourage saving for a chosen beneficiary’s future higher education expenses.
 

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The Kiddie Tax does not apply to interest collected on 529 plans and custodial 529 plan accounts. 529 programs are investment accounts that ‌assist people in saving for college. They make contributions after-tax dollars, and any interest generated is tax-deferred. When the funds are used to pay for eligible higher education expenses, distributions are totally tax-free.
 

The Kiddie Tax‌ applies to investment earnings in other custodial accounts. To take advantage of the tax benefits, they can convert custodial accounts used for college savings to custodial 529 plan accounts. Traditional custodial accounts have a greater impact on a student’s need-based financial aid eligibility than custodial 529 plan accounts.

Essential Points To Note Regarding Kiddie Tax:

  •  The kiddie tax stops parents from avoiding taxes by giving big stock presents to their children.
  • Over the threshold, they tax all unearned income at the parent’s marginal income tax rate rather than the lower child’s rate.
  • It covers all children under the age of 18 years old, as well as dependent full-time students aged 19 to 24.
  • They levy the kiddie tax on most unearned income received by a child, but not on any pay or wages.
  • Under the child tax code, unearned income under $1,150 qualifies for the standard deduction in 2022.

Frequently Asked Questions (FAQs)

When should you stop claiming your child as a dependent?

You can claim dependent children until they turn 19 years old, according to the federal authorities. If they attend college, this age limit is raised to 24.

What is the Kiddie Tax threshold?

The kiddie tax threshold for 2021 is $2,200, adjusted for inflation each year. In addition, the child tax threshold for 2022 is $2,300.

What support requirement?

Food, shelter, clothes, medical treatment, and education are all considered “support” under the kiddie tax regulations. The amount of help a parent provides to a child aged 18 to 23 can influence whether the youngster’s unearned income is liable to the kiddie tax. Children under the age of 18 are exempt from support requirements.

How is kiddie tax reported?

They record the tax for certain children with unearned income on Form 8615, which is attached to the child’s Form 1040.

Conclusion

The Kiddie Tax is an important notion to adopt if you’re a college student who’s been building an investment portfolio or the parent of a prospective investor. It is, in reality, a significant investment that you will not be sorry for.

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