Understanding the Kiddie Tax: What You Need to Know

The Tax on a Child’s Investment or Other Unearned Income, commonly referred to as the “kiddie tax,” is a special tax law focused on certain unearned income of children. 

Before we dive deeper into the kiddie tax itself, let’s first make sure we understand unearned income. Generally, this phrase refers to all income other than earned income (which is taxable income or wages you get for working for someone else or yourself, or from a business or farm that you own). 

On the other hand, unearned income refers to income that the recipient did not earn through work but instead acquired passively. It includes investment-type income such as:

• Taxable interest
• Dividends
• Capital gains (including capital gain distributions)
• Rents
• Royalties
• Taxable Social Security benefits
• Pension and annuity income 
• Taxable scholarship and fellowship grants not reported on Form W-2 
• Unemployment compensation
• Alimony
• Unearned income received as the beneficiary of a trust. 

Unearned income includes amounts produced by assets the child obtained with earned income (such as interest on a savings account into which the child deposited wages).

The kiddie tax, which passed as part of the Tax Reform Act of 1986, was created to discourage wealthy parents from exploiting a loophole in the tax code related to unearned income. 

Children are usually taxed at a significantly lower rate than their parents—sometimes as low as 0%! That means that, previously, parents could avoid higher taxation on investment income assets by placing them under their child’s name as a gift, thereby causing any gains realized from the assets to be taxed at the child’s lower rate. 

The kiddie tax closes this loophole by taxing all unearned income over a certain threshold at the parent’s marginal income tax rate. 

How does the kiddie tax work?

Individuals (children 18 years old or under at the end of the tax year and full-time students between the ages of 19 and 24) who are dependents are subject to the kiddie tax when their investment and unearned income exceeds an amount the IRS determines each year. Anything over the annual dollar limit is subject to taxation at the parent or guardian’s rate.  

In 2021, this limit was $2,200, with the first $1,100 qualifying for the standard deduction and the next $1,100 taxable at the child’s rate if the child files their return (more on this shortly). In 2022, unearned income under $1,150 qualifies for the standard deduction, with another $1,150 taxable at the child’s rate (again, provided the child files their return). That makes the threshold for this year slightly higher at $2,300. 

There are some exceptions to the kiddie tax. For example, if the child has earned income exceeding half the cost of their support, or if the child files tax returns as married filing jointly, they may not be subject to the kiddie tax. Additionally, earned income a child might earn from a summer job, such as salary, wages, or tips, and income from self-employment, like mowing the neighbor’s lawn, is not subject to this tax. 

It is also important to note that children who turn 19 (or 25, if they are dependent full-time students) by the end of the tax year are excepted from the kiddie tax, as well. 

The 2017 Tax Cuts and Jobs Act (TCJA) temporarily changed the rules by taxing the qualifying child’s investment income totaling more than $2,200 at the rates that apply to trusts and estates, rather than at the parent’s marginal tax rate. However, after a backlash, Congress reversed this provision of the TCJA and retroactively changed back to the old rules for applying the kiddie tax.