Do your children have income-generating assets (such as stocks) or unearned income (such as interest income, capital gains distributions, or dividends from those stocks)?
If so, you need to understand something called the kiddie tax.
Even if your child is a 24-year-old full-time college student with their own investment portfolio, you, as a parent, need to be aware of this particular tax law, which can have considerable ramifications for both you and your offspring.
For example, some parents feel tempted to include their child’s unearned income on their own tax return in the interest of simplicity. However, depending on your tax bracket, doing so can increase your tax burden — which means it could be a costly mistake.
Furthermore, it’s never too early to begin talking to your child about financial planning, especially if they already have investments. After all, your child’s financial future is your financial future, too.
To gain a greater understanding of what the kiddie tax is, how it works, who is subject to the kiddie tax, and how to minimize your child’s exposure to the kiddie tax, read on below.
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:
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.
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.
As discussed above, if your child is in a qualifying age range at the end of the tax year and their investment and unearned income exceeds the annual limit, they may be subject to the kiddie tax in 2022.
There are also some additional requirements: At least one of the child’s parents must be alive at the end of the tax year, and the child must be required to file a tax return for the year. Additionally, as mentioned above, a child who files a joint return for the year is not subject to paying the kiddie tax.
How much kiddie tax a child must pay will depend on how much-unearned income the child has accrued and whether or not the parent elects to include the child’s income on their own tax return.
If a child’s earned and unearned income totals more than $11,000, they must file their own tax return. However, suppose the child’s only income for the year comes from interest, dividends, and capital gains distributions totaling less than $11,000. In that case, the parent may be able to include the income on their return by filling out Form 8814, Parent’s Election to Report Child’s Child’s Interest and Dividends. If the parent chooses to go this route, the child will not have to file their own return.
There are benefits to this approach, not least among them convenience. Additionally, while the first $1,150 of the child’s unearned income qualifies for the standard deduction (making it effectively untaxed), the next $1,150 may be subject to a 10% tax rate with a $110 maximum if the parent includes the child’s income on their return.
There are also drawbacks, however. For example, this approach could increase the parent’s tax burden by exposing the child’s income to additional taxes, eliminating itemized deductions, and increasing tax on capital gains and qualified dividends.
Either way, the IRS will tax any unearned income possessed by the child over the $2,300 threshold at the parent’s marginal tax rate.
As with any tax, there are ways you can legally minimize the amount you owe. The easiest way is to keep your child’s investment and other unearned income below the $2,300 annual threshold. Choosing investments that do not pay interest or dividends or mutual funds or index funds that you won’t need to sell until after your child is no longer subject to the kiddie tax are both effective ways to avoid paying kiddie tax. After all, you can’t be subject to taxation on interest or dividends that don’t exist!
Using a 529 plan to gift investments to your child can allow you to help your child pay for qualified educational expenses while avoiding the kiddie tax, as the IRS does permit 529 investments to grow tax-free and remain untaxed upon withdrawal. A Roth IRA can also be a helpful tool for saving money that won’t generate tax liability upon distribution.
Ultimately, however, the kiddie tax is highly complicated, and failing to take it seriously or understand how it will impact you and your child can have surprising financial consequences.
When it comes to making sure you and your child can best navigate the kiddie tax, there is no substitute for the advice of a tax professional.
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Jeff Coyle, CPA, Partner of Rosenberg Chesnov, has been with the firm since 2015. He joined the firm after 20 years of business and accounting experience where he learned the value of accurate reporting, using financial information as a basis for good business decisions and the importance of accounting for management.
He is a diligent financial professional, able to manage the details and turn them into relevant business leading information. He has a strong financial background in construction, technology, consulting services and risk management. He also knows what it takes to create organizations having built teams, grown companies and designed processes for financial analysis and reporting.
His business experience includes:
Creating and preparing financial reporting, budgeting and forecasting.
Planning and preparation of GAAP and other basis financial statements.
Providing insight on financial results and providing advice based on those results.
Jeff also has a long history of helping individuals manage their taxes and plan their finances including:
Income tax planning and strategy.
Filing quarterly and annual taxes.
General financial and planning advice.
Prior to joining the firm in 2015, Jeff was in the private sector where he held senior financial and management positions including Controller and Chief Financial Officer. He has experience across industries, including construction, technology and professional services which gives him a deep understanding of business.
Jeff graduated from Montclair State University, he is a CPA and member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and New Jersey State Society of Public Accountants.
Jody H. Chesnov, CPA, Managing Partner of Rosenberg Chesnov, has been with the firm since 2004. After a career of public accounting and general management, Jody knows the value of good financials. Clarity, decision making, and strategy all start with the facts – Jody has been revealing the facts and turning them into good business results for more than three decades.
He takes a pragmatic approach to accounting, finance and business. His work has supported many companies on their path to growth, including helping them find investors, manage scaling and overcome hurdles. His experience and passion for business reach beyond accounting and he helps businesses focus on what the numbers mean organizationally, operationally and financially.
He has a particular expertise in early-stage growth companies. His strengths lie in cutting through the noise to come up with useful, out of the box, solutions that support clients in building their businesses and realizing their larger visions.
Prior to joining the firm in 2004, Jody was in the private sector where he held senior financial and management positions including General Manager, Chief Financial Officer and Controller. He has experience across industries, which gives him a deep understanding of business.
Jody graduated with a BBA in Accounting from Baruch College, he is a CPA and member of the American Institute of Certified Public Accountants and New York State Society of Certified Public Accountants.
In addition to delivering above and beyond accounting results, Jody is a member of the NYSCPA’s Emerging Tech Entrepreneurial Committee (ETEC), Private Equity and Venture Capital Committee and Family Office Committee.
He is an angel investor through the Westchester Angels, and has served as an advisor for many startup companies and as a mentor through the Founders Institute.
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