In 1986, a tax law was introduced to block parents from transferring investments to their children as a technique to lower their taxes. This law, commonly known as the kiddie tax, ensures that this unearned income is taxed at a parent’s, usually higher, tax rate. But there is still a tax planning opportunity.
The term “kiddie tax” was introduced by the Tax Reform Act of 1986. The IRS introduced this rule to keep parents from shifting their investment income to their children and have this income taxed at their child’s lower tax rate. The law requires a child’s unearned income (generally dividends, interest, and capital gains) above a certain amount ($2,000 in 2013) to be taxed at their parent’s tax rate. Here is what you need to know.
Who it applies to
- Children under the age of 19
- Children under the age of 24 if a full-time student and providing less than ½ of their own financial support
- Children with unearned income above $2,000
Who/What it does NOT apply to
- Earned income (wages and self-employed income from things like babysitting or paper routes).
- Children that are over age 18 and have earnings providing more than ½ of their support.
- Older children married and filing jointly
- Children over age 19 that are not full-time students
- Gifts received by your child during the year
How it works
- The first $1,000 of unearned income is generally tax-free
- The next $1,000 of unearned income is taxed at the child’s (usually lower) tax rate
- The excess over $2,000 is taxed at the parent’s rate either on the parent’s tax return (Form 8814) or on the child’s tax return (Form 8615)
What to know/do now
- Maximize your low tax investment options. Look to generate gains on your child’s investment accounts to maximize the use of your child’s kiddie tax threshold each year. You could consider selling stocks to capture your child’s investment gains and then buy the stock back later to establish a higher cost basis.
- Be careful where you report a child’s unearned income. Don’t automatically add your child’s unearned income to your tax return. It might inadvertently raise your taxes in surprising ways by exposing more income to the Alternative Minimum Tax or reducing your tax benefits in other programs like the American Opportunity Credit.
- Leverage gifts. If your children are not maximizing their tax-free investment income each year consider gifting funds to allow for unearned income up to the kiddie tax thresholds. Just be careful, as these assets can have an impact on a child’s financial aid when approaching college age years.
Properly managed, the “kiddie tax” rules can be used to your advantage. But if not properly managed, this part of the tax code can create an unwelcome surprise at tax time.