What Is the Kiddie Tax, and Why Does It Matter for You?

Children are generally taxed at a lower rate than their parents. In the past, that fact led some wealthy parents to transfer investments to their children’s names. Income on the investments was then taxed at the child’s more favorable rate rather than that of the parents. Not surprisingly, the Internal Revenue Service acted to close this “loophole,” and the “kiddie tax” was born in 1986.

What is the kiddie tax? In a nutshell, it’s a tax on children’s unearned income. Originally, the kiddie tax applied to the investment income of children under the age of 14. The tax imposed the parents’ marginal tax rate on the child’s investment income, which largely eliminated the tax benefit the parents sought by transferring the investment into the child’s name. However, determining the amount of tax due often became complicated, especially when parents were divorced, or married but filing income tax separately.

Since it was originally enacted, the kiddie tax has undergone a number of changes. And it can affect families of more modest means, as well as those who are in a position to put vast real estate holdings in their kindergartener’s name.

Changes to the Kiddie Tax Over Time

While the original kiddie tax applied to children under the age of 14, it has since been expanded to affect dependent children who are under the age of 18 (and full-time students under the age of 24) at the end of the tax year.

There have been other changes as well. The Tax Cuts and Jobs Act of 2017 applied the tax brackets and rates that normally applied to trusts to children’s unearned income. As a result, that income was often taxed at rates even higher than the parents’ tax rates. That modification was swiftly reversed after a backlash by taxpayers, and the kiddie tax was returned to parents’ rates.

Parents who paid the higher rates on behalf of their children in 2018 and 2019, the years during which they applied, may be able to amend their tax return to apply the parents’ rate and receive a refund of some of the tax paid.

How Does the Kiddie Tax Work?

In 2021, the kiddie tax is calculated as follows:

• A child’s unearned income under $1,100 is not taxed.
• The next $1,100 of the child’s unearned income is taxed at the child’s tax rate.
• The child’s unearned income in excess of $2,200 is taxed at the parents’ rate.

Depending on the situation, the child may file their own tax return, or the parent may choose to report the child’s unearned income (such as interest, dividends, and capital gains distributions) on their own income tax return. A child with more than $12,400 in combined earned and unearned income must file their own income tax return. A child who has only unearned income totaling less than $11,000 can usually have that income reported on their parents’ taxes using IRS Form 8814. Regardless of the filing method, unearned income above $2,200 will be taxed at the parents’ marginal rate.

Estate Planning and Tax Consequences

The kiddie tax was designed to prevent wealthy parents from dodging their tax obligations by putting investment property in their children’s names. In that sense, it has been successful. But as mentioned above, individuals with outrageous wealth are not the only ones who may feel the bite of the kiddie tax.

The kiddie tax was designed to prevent wealthy parents from dodging their tax obligations by putting investment property in their children’s names. In that sense, it has been successful. But as mentioned above, individuals with outrageous wealth are not the only ones who may feel the bite of the kiddie tax.

Any parent who creates a custodial account on behalf of their child could conceivably have to pay kiddie tax. A custodial account is any savings account that an adult establishes for a minor (up to age 18 or 21, depending on state law). A custodial account may be at a financial institution like a bank, or with a brokerage firm or mutual fund company.

Many parents or grandparents choose to establish a custodial account to save for a child’s future. Uniform Transfer to Minors Act (UTMA) and Uniform Gifts to Minors Act (UGMA) accounts have tremendous flexibility, no income limits or distribution requirements, and allow the adult to manage the funds for the child until he or she reaches the age of majority. Despite the many benefits of custodial accounts, adults who establish them often fail to realize the potential tax consequences as the account grows and produces significant income.

How to Reduce Tax

There are a few strategies for reducing or avoiding the kiddie tax. One is to keep your child’s investment income low. You can do that by choosing investments that won’t pay interests or dividends, and which therefore will not yield unearned income. You may also want to invest in index funds or mutual funds, which can be held for decades, rather than individual stocks, which are more likely to need to be sold as value fluctuates.

If saving for a child’s future college expenses, you can also choose to invest in a 529 plan. A 529 plan can help avoid the kiddie tax and has other benefits as well. However, it can also affect the financial aid for which a child is eligible, so you may want to consult your investment professional or financial advisor to weigh the costs and benefits.

Lastly, for children who are interested in investing on their own, especially money they have earned, a Roth IRA may be an excellent option. After-tax dollars invested in a Roth IRA grow tax free for decades. Your child will not have to pay income tax on funds withdrawn after he or she reaches retirement age.

To learn more about strategies to avoid or reduce the kiddie tax, please contact our law office to schedule a consultation.