After our last post on “Understanding The Kiddie Tax (And 2 Good Ways to Avoid It)”, we realize that many of you may have a lot more questions…such as “what is unearned income?”
So in this post, we’ll do some Q&A on the topic of minors and taxes.
What Is Unearned Income?
Investopedia puts it best: “Simply put, unearned income is money you earn by doing nothing.”
Unearned income is money that comes to you from any source other than a traditional job where you trade time and energy to an employer in return for a paycheck. If you receive a W-2 or 1099 at the end of the year, that job is considered earned income (think salary, wages, or revenue from a business); everything else is unearned. Money from those sources came to you without your direct involvement or time.
The IRS goes into a little more detail in their official definition: “Unearned income includes investment-type income such as taxable interest, ordinary dividends, and capital gain distributions. It also includes unemployment compensation, taxable social security benefits, pensions, annuities, cancellation of debt, and distributions of unearned income from a trust.”
Other examples of unearned income are
- Inheritance money
- Veteran’s benefits payments
- Prize money
- Lottery winnings
- Child support
- Alimony payments
- Rental property income
- Insurance payouts
Income from these and other unearned sources are treated differently than regular income by the IRS. Unearned income is not subject to payroll taxes and Medicare/Social Security withholdings. Whether or not unearned income is taxed (and how much) depends on its source. For instance, money from an insurance policy payout is not taxed at all.
If Susan makes an annual salary of $65,000 and receives a year-end bonus of $5,000, her earned income is $70,000. If she also gets $8,000 as an investment dividend, it will be taxed separately at a capital gains rate since it is unearned income.
Another important factor to keep in mind when it comes to unearned income is that it doesn’t only apply to adults. Children can also receive unearned income, and the IRS expects that to be reported as well.
Do Minors Have to Pay Taxes?
Yes, if they meet a certain threshold. Children who have income are not exempt from paying taxes on it (after a certain point.)
Minors under the age of 14 are generally not allowed to work in traditional jobs. From ages 14-18, the rules regarding how much minors are permitted to work vary slightly from state to state.
Here in Tennessee, where our firm has offices in Jackson, Dyersburg, Paris, Brownsville, Martin, Milan, and the new Blue Oval City, our Child Labor Act specifies that children who are 14/15 years old can work no more than 3 hours a day up to 18 hours a week during the school year. By 16 and 17, they can work longer and later hours in traditional jobs.
The U.S. Department of Labor’s Fair Labor Standards Act states that children doing babysitting, acting, doing household chores for a private residence, or working as part of a family business or agricultural operation may fall under more lenient rules when it comes to how much they can work.
But (generally speaking) if a minor makes money they will have to pay taxes on it if they meet any of the following IRS requirements for tax year 2022:
- They have unearned income greater than $1,150.
- They have earned income greater than $12,950.
Their standard deduction is determined by the larger of $1,150 or their earned income plus $400, and it tops out at an amount equal to the standard deduction for adult single taxpayers of $12,950.
Does a Minor Have To File Taxes?
The IRS requires that everyone who has a gross income above a certain threshold file a tax return each year. Unlike adults, though, children have some flexibility when it comes to filing their taxes.
It is ultimately each person’s responsibility to file their own tax return. However, if a child is not old enough to understand the process well enough, the parents become responsible for ensuring it is done. Parents can either:
- File a separate return on behalf of the child, or
- Include the child on their return
Depending on the situation there are advantages and possible disadvantages to both options.
- If your child has earned income (even if it is less than the 2022 standard deduction threshold of $12,950), filing a return could result in them getting a refund. It depends on how much tax was taken out of their paychecks during the year.
- If your child’s unearned income is generated by interest and dividends, you may opt to include it on your personal return. However, be careful that the total combined income doesn’t push you into a higher marginal tax bracket causing you both to pay more than necessary. Your tax advisor can help you determine whether it is better to include your child on your return or file separately.
Is Capital Gains Considered Earned Income?
When you make money on the sale of a stock or other investment, that is considered a capital gain. The sale of items such as cars and real estate can also apply. If you sell it within a year of originally acquiring it, that is considered a short-term capital gain. If you sell it after more than a year, it is considered a long-term capital gain.
- Short-term capital gains are considered ordinary income and are taxed at your marginal rate.
- Long-term capital gains are not considered ordinary income, and it is taxed at a different rate: 0%, 15%, or 20% depending on your situation.
Help With The Difference Between Earned and Unearned Income
The Consumer Financial Protection Bureau has created a great guide on distinguishing between earned and unearned income. You can use it as a teaching tool with your children–it is designed for middle schoolers–to help them better understand how to handle their money if they are in the position of benefiting from earned or unearned sources of income. Or use it yourself as a refresher!
We Can Help You Sort It All Out.
We get it, taxes can be confusing. That’s why we’re here to help.
When it comes to filing your child’s earned and unearned income the right way (and the best way to minimize the impact on your taxes), trust our tax pros that have been helping people for over 40 years! Schedule a call today to find out what we can do for you, and discover what it means to “expect more from your CPA.”