What is the kiddie tax?

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. 

Does your child have to pay 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 is 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. 

Can you minimize exposure to the kiddie tax?

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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