Understanding The Kiddie Tax (And 2 Good Ways to Avoid It)

Dec 14, 2022 | Taxes

Your child may be too young to drive, vote, drink, or serve in the military. But that doesn’t mean the IRS isn’t paying attention. 

We all understand that taxes are taken out of a regular paycheck if they are working a traditional job that involves a W-2. However, if your minor is making money from an unearned source, they could be subject to something known as the “Kiddie Tax”.

“What is the Kiddie Tax?”, you say. That’s what we’ll cover today so you aren’t caught by surprise when tax time rolls around in a few short months. So keep reading!

when does kiddie tax apply?

What Is The Kiddie Tax

The Kiddie Tax is something the IRS set up so that all unearned income above a certain amount is taxed at the parent’s tax rate, not the child’s. 

The Kiddie Tax was created in 1986 as part of the Tax Reform Act. Prior to that time, some clever parents figured out that they could hide some of their own investments in accounts designated for their children in order to take advantage of lower tax rates. 

Prior to 1986, investment income and other unearned sources for children under 14 were automatically taxed at the parent’s marginal rate, since children under 14 aren’t legally able to work. So savvy families began gifting stocks to their 16–18-year-olds who were taxed at a much lower “child’s rate” in order to bypass the rules for a couple of years.

In 2017, the Kiddie Tax rate was changed to where it was taxed at the rate for trusts and estates. The only problem was that children’s unearned income was suddenly being taxed at a rate higher than that of their parents in some cases. After enough people complained, the Kiddie Tax rate was reverted back to the parent’s rate in 2020.

Special side note: For people who ended up paying the higher rate in 2018 and 2019, Congress created a provision that allows you to go back and retroactively file amended returns at the parent’s tax rate instead if you wish. You have up to 3 years to amend the return, so talk to your tax advisor to see if the time and paperwork are worth the savings. If you’re in a lower or middle tax bracket, it might save you some money.

Even though it has gone through a few changes over the years, the Kiddie Tax has effectively closed the loophole that wealthier families had been using to say “oh, I wish we could pay our extremely high marginal tax rate on that lucrative stock, but unfortunately, it was purchased in my child’s name, not mine.”

Now, let’s look at when it applies and what rules you need to pay attention to.

When Does the Kiddie Tax Apply

The Kiddie Tax applies to any child age 18 and under at the end of the tax year as well as dependent full-time students aged 19-24. If they have interest money, dividends, or unearned income above $2,200 they must pay taxes at the parent’s rate if it is higher than the child’s.

The IRS defines “unearned income” as:

“… all income other than salaries, wages, and other amounts received as pay for work actually performed (earned income). It includes taxable interest, dividends, capital gains (including capital gain distributions), rents, royalties, pension and annuity income, taxable scholarship and fellowship grants not reported on Form W-2, unemployment compensation, alimony, the taxable part of social security and pension payments, and income (other than earned income) received as the beneficiary of a trust.”

Kiddie Tax Threshold

The following rules apply when it comes to calculating how much of a minor’s unearned income is taxed: 

  • As of the 2020 rules, a child’s unearned income below $1,100 is not taxed at all.
  • The next $1,100 is taxed at the child’s tax rate. 
  • Any unearned income above $2,200 is then taxed at the parent’s marginal tax rate.

How to File Kiddie Tax

In most cases, parents of children who need to report unearned income under the Kiddie Tax have a couple of options. They can either file a separate return for their child, or they can include it with their own return.

  • Parents including their child’s unearned income on their return need to use IRS Form 8814.
  • Parents filing a separate return in the child’s name need to use IRS Form 8615.

If the unearned income in question is greater than $11,000, the IRS requires a separate return for the child.

We get it. Forms like these can be overwhelming. Don’t worry, though. Our team of tax experts can help you with either of these forms or any questions you have about the whole process.

how to avoid the kiddie tax

How to Avoid the Kiddie Tax

It’s possible that you could manage your child’s income in such a way that you can lower the impact of the Kiddie Tax (or avoid it altogether).

A 529 plan that saves towards a child’s college education is a great place to put money where it can grow tax-free (assuming you ultimately use it only for educational expenses). Check out a post we did a couple of years ago on what you need to know about 529 college savings plans.

You can also invest up to $6,000 each year of their earned income into a Roth retirement account. Fidelity has a good article on how to “turbocharge your child’s retirement” with a Roth IRA for kids.

If Kiddie Tax Rules Apply to You, We Can Help

Don’t let the income that your child has received this year add to an already stressful tax situation in your life. Our team believes that you deserve to be able to make it through filing your returns with as little trouble as possible.

For over 40 years, we’ve come alongside parents just like you who have needed to report the earned and unearned income of their children. Schedule a call with our tax pros today and find out how we can help you too!

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