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Understanding the Kiddie Tax: How Children’s Investment Income is Taxed

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In taxation, few concepts spark as much curiosity and confusion as the Kiddie Tax. This unique tax provision is one of the lesser-known aspects of the US tax code and has been put in place to address a specific scenario for families: the investment income of children.

January 9, 2024
Author: NCH

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 While most taxpayers are familiar with the basic principles of income taxation, the rules surrounding children’s unearned income can be confusing and often overlooked. 

What is the Kiddie Tax?

The Kiddie Tax is a specialized tax provision that addresses a specific tax avoidance strategy commonly used by families. 

This tax provision aims to prevent parents from shifting their investment income to their children, who might be subject to lower tax rates due to their lower income levels. 

By taxing a child’s unearned income at the parent’s marginal tax rate, the Kiddie Tax can maintain fairness and discourage tax sheltering strategies.

Generally, the Kiddie Tax affects children under the age of 18. However, this tax provision can also impact full-time students aged 19-23. 

Taxation of Children’s Investment Income

What types of income are subject to the Kiddie Tax?

Children’s investment income, often called “unearned income,” forms the core of this tax provision. This includes dividends, interest, capital gains, and rental income – earnings that stem from investments rather than traditional employment.

  • Interest Income: This includes earnings from savings accounts, certificates of deposit (CDs), bonds, and other interest-bearing investments.
  • Dividend Income: Dividends earned from stocks and mutual funds are considered unearned and subject to the Kiddie Tax.
  • Capital Gains: Profits from the sale of investments, such as stocks, real estate, or other assets, fall under capital gains. Both short-term and long-term capital gains are subject to the Kiddie Tax.
  • Rental Income: If a child owns a rental property or receives rental income from investments, this income could also be subject to the Kiddie Tax.

How is the Kiddie Tax computed?

  1. Determine Unearned Income: Add up the child’s unearned income, including interest, dividends, and capital gains.
  2. Identify Parent’s Marginal Tax Rate: Find the parent’s marginal tax rate, considering their total taxable income and tax bracket.
  3. Apply Kiddie Tax Threshold: Check if the child’s unearned income exceeds the Kiddie Tax threshold (which is subject to change). If it does, proceed to the next step.
  4. Calculate Taxable Kiddie Income: Subtract the Kiddie Tax threshold from the child’s unearned income. This amount is the child’s taxable kiddie income.
  5. Calculate Kiddie Tax: Apply the parent’s marginal tax rate to the child’s taxable income. The result is the Kiddie Tax amount.
  6. Add to Child’s Tax Return: Include the Kiddie Tax on the child’s tax return, and note it as an additional tax.

A child’s tax rate is determined by applying the parent’s marginal tax rate to the child’s unearned income subject to this tax. If the tax calculated using the parent’s rate is higher than the child’s regular tax calculated based on their income, the higher tax amount applies. 

Kiddie Tax vs. Parent’s Tax Rate

The Kiddie Tax employs a distinct approach to taxing children’s investment income. Instead of the conventional graduated tax brackets, it harnesses the parent’s marginal tax rate to ensure equity. This contrasts with the alternative of taxing the child’s unearned income at their rate. 

Certain circumstances warrant a closer examination of the parent’s rate as opposed to the Kiddie Tax. If the child’s unearned income remains within a lower bracket than the parent’s rate, applying the parent’s rate might be financially prudent. This scenario often arises when the parent’s income is relatively lower, resulting in a potential tax advantage.

While utilizing the parent’s rate ensures equity and thwarts tax avoidance, it might also result in higher tax liability. Conversely, taxation at the child’s rate might lead to lower taxes, but it requires careful consideration of potential tax sheltering. 

Exceptions and Exemptions

Certain types of tax-deferred investments are exempted from its grasp. Earned income, such as wages or salaries from part-time jobs, is typically excluded from the Kiddie Tax calculation. This exemption acknowledges the difference between earned and unearned income, offering a degree of financial freedom for children with active employment.

In addition to exemptions, exceptions carve out special circumstances in which the Kiddie Tax may not apply. For instance, full-time students aged 19-23 might enjoy an exception, allowing them to avoid the Kiddie Tax, provided their unearned income does not exceed the threshold. This recognition of student status acknowledges the transitional nature of educational pursuits and aims to alleviate financial burdens for young scholars.

To optimize tax efficiency and investment growth, families can explore the strategic utilization of tax-advantaged accounts for their children. Accounts like 529 plans or custodial accounts can offer tax benefits, shielding investments from excessive taxation.

Recent Changes to the Kiddie Tax

The Tax Cuts and Jobs Act (TCJA) of 2017 significantly changed the Kiddie Tax landscape. Under the TCJA, children’s unearned income, previously taxed at their parent’s rate, was subject to trust and estate tax rates instead. This shift aimed to align taxation for children with the taxation of trusts and estates, altering the Kiddie Tax calculation.

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However, recognizing the complexities and unintended consequences of the TCJA provisions, legislation was introduced to reverse these changes. The Further Consolidated Appropriations Act of 2020 repealed the TCJA’s amendments, reinstating the previous method of taxing children’s unearned income at their parent’s rate.

Ways to Minimize the Kiddie Tax

As families navigate the intricacies of the Kiddie Tax, strategic approaches emerge to mitigate its impact, offering a clearer path toward optimizing tax outcomes.

1. Shift Investments to Tax-Advantaged Accounts

Accounts like 529 plans or custodial accounts offer a sanctuary for growth, shielding investments from immediate taxation. By strategically allocating resources to these accounts, families can potentially reduce the unearned income subject to the Kiddie Tax, fostering long-term financial stability for the child.

2. Time Income and Capital Gains Realization

Timing is pivotal in minimizing the Kiddie Tax impact. Families can strategize by deferring income or capital gains realization to years when the child’s overall unearned income remains below the Kiddie Tax threshold. This approach aims to keep the child’s taxable income at a level that avoids triggering the tax provision, effectively reducing the tax burden.

3. Leverage Education Tax Credits and Deductions

Utilizing education-related tax credits and deductions can be a valuable tool in offsetting the effects of the Kiddie Tax. By maximizing benefits such as the American Opportunity Credit or the Lifetime Learning Credit, families can potentially reduce their overall tax liability, indirectly easing the impact of the Kiddie Tax on the child’s investment income.

Reporting and Compliance

Filing Requirements for the Kiddie Tax

If a child’s unearned income exceeds a certain threshold (which can vary based on tax laws), they may be required to file a separate tax return. This IRS Form 8615 ensures accurate reporting and calculation of the Kiddie Tax. Additionally, the child’s parents might need to include Form 8814 when filing their tax return to reflect the Kiddie Tax calculation. 

Proper Documentation and Record-Keeping

Maintaining accurate and organized records ensures compliance with tax regulations and can be beneficial in case of audits or inquiries.

Here are some key aspects of proper documentation and record-keeping for the Kiddie Tax:

  • Income Sources: Keep records of all sources of the child’s unearned income, such as interest statements, dividend statements, and capital gains from investment transactions.
  • Calculations: Document the calculations used to determine the child’s taxable unearned income and the Kiddie Tax amount, including any deductions or exemptions applied.
  • Filing Forms: Keep copies of all filed tax forms related to the Kiddie Tax, such as IRS Form 8615, and ensure they are accurately completed.
  • Supporting Documents: Retain supporting documents that justify any deductions, exemptions, or credits claimed in relation to the Kiddie Tax.
  • Bank and Investment Statements: Maintain bank statements and investment account statements, showing deposits, withdrawals, and investment activity.
  • Duration of Record-Keeping: Keep records for at least three years, as this is the standard time frame for potential IRS audits.

Penalties for Noncompliance

Noncompliance with the Kiddie Tax regulations can lead to potential penalties and consequences. Some penalties could result from noncompliance, such as:

  • Underpayment Penalties: If the Kiddie Tax is not properly calculated or paid, underpayment penalties may apply. These penalties are assessed if the correct amount of tax owed was not paid by the due date.
  • Accuracy-Related Penalties: Inaccurate reporting or failure to provide proper documentation could result in accuracy-related penalties. These are imposed if there is a substantial understatement of tax or if negligence or disregard of the rules is evident.
  • Late Filing Penalties: Failure to file the required tax forms on time can lead to late filing penalties. The penalty amount typically increases the longer the return is overdue.
  • Interest Charges: In addition to penalties, interest charges may accrue on unpaid Kiddie Tax amounts, starting from the original due date of the tax return.

Seek Professional Advice

Our tax professionals at NCH are here to provide expert guidance and assistance with understanding and navigating the complexities of the Kiddie Tax. Whether you have questions about which types of income are subject to the Kiddie Tax, how to calculate the tax, or what strategies can be employed to minimize its impact, our team of experts is ready to help.

Call us at 1-800-508-1729 to book a consultation!

DISCLAIMER: The above material has been prepared for informational purposes only, containing opinions of the provider, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Please consider consulting tax, legal, and accounting advisors before engaging in any transaction.

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