Kiddie Tax – What a Parent Needs to Know | Leung, Louie, Ip & Co. LLP

Article Highlights:

Who Is Subject to The Kiddie Tax
Exceptions
Kiddie Tax Rules
Strategy Where the Child Has Earned Income
Parents Election to Include Child’s Unearned Income on Their Return
Strategy To Avoid Kiddie Tax

The Kiddie Tax was introduced in 1986 to prevent high-income parents from shifting their investment income to their children, who typically fall into lower tax brackets. While the term “Kiddie Tax” isn’t used in the tax code, it does succinctly describe this tax. The tax applies to unearned income, such as dividends, interest, and capital gains, of certain children under the age of 19, or under 24 if they are full-time students who aren’t self-supporting.

However, if the child is married or neither parent is alive on the last day of the year, the Kiddie Tax rules will not apply to the child and the child will be taxed at their own rate.

For 2023, the first $1,250 of a child's unearned income is tax-free. The next $1,250 is taxed at the child's rate, which is typically lower than the parents' rate. However, any unearned income over $2,500 is taxed at the higher of the child’s tax rate or the parents' rate, which can be as high as 37%. These amounts are inflation adjusted and for 2024 will be $1,300 and $2,600.

Where a child has earned income (income from working, generally W-2 income) that income is taxed at the child’s marginal rate. However, thanks to the standard deduction, which can offset earned income, and for 2023 for a single individual is $13,850, a child can earn$13,850 tax free. Inflation-adjustment is expected to bring the 2024 standard deduction to $14,600.

Earned Income Strategy: The child may also make deductible contributions to a traditional IRA for 2023 of the lesser of their earned income or $6,500. By combining the standard deduction and the maximum deductible IRA contribution, a child could earn $20,350 ($13,850 + $6,500) of wages and pay no income tax. If the child balks at contributing his or her hard-earned money to an IRA, the parent, or grandparents, might consider giving the child part or all of the IRA contribution as a gift. For long-term retirement benefits, it might be better to have the child contribute to a Roth IRA. Even though contributions to a Roth IRA are not tax deductible, all earnings are tax free at retirement which can be a huge benefit 50 or 60 years down the road.

In some cases, parents may elect to include their child's interest and dividend income (including capital gain distributions) on their own tax return instead of the child filing a return of his/her own. If the child has other types of income, either earned or unearned, this election cannot be made. Where the child’s parents are not filing a joint return there are some complicated rules related to which parent includes the child’s unearned income on their return. Generally, it would be reported on the return of the parent with the highest amount of taxable income.

The IRS no longer allows children who have unearned income and are subject to the Kiddie Tax to file their returns using estimated parental tax information. If a child cannot get the required information about the parent's tax return, the child (or the child's legal representative) can request the necessary information from the IRS.

Kiddie Tax Avoidance Strategy - It is possible to avoid the Kiddie Tax by placing or moving a child's funds into investments such as the following that produce little or no current taxable income (that would otherwise be subject to the Kiddie Tax), at least in the years until the investments need to be sold or redeemed to pay for education expenses:

U.S savings bonds – Interest can be deferred until the bonds are cashed.
Tax-deferred annuities - Interest can be deferred until the annuity is surrendered.
Municipal bonds – Generally produce tax-free interest income (may be taxable to the state).
Growth stocks - Stocks that focus more on capital appreciation than current income.
Unimproved real estate – That provides appreciation without current income.

Navigating the complexities of the Kiddie Tax can be challenging. However, with a solid understanding of its implications, you can make informed decisions that align with your financial goals.

Remember, every family's financial situation is unique, and what works for one may not work for another. If you have questions about the Kiddie Tax or need assistance with tax planning, don't hesitate to give this office a call.

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Kiddie Tax – What a Parent Needs to Know

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