The “Kiddie Tax” is a law that stipulates how investment and unearned income are treated for minors or full-time college students under the age of 24. Before the Kiddie Tax, parents could save on taxes by putting investment accounts in a child’s name. Parents would gift stocks and other assets to their children, and income earned on the assets would be taxed at the child’s (lower) income tax rate, instead of the parent’s (higher) income tax rate. The Kiddie Tax closed this loophole by taxing children’s passive income at higher rates.
History of the Kiddie Tax
The Kiddie Tax was created as part of the Tax Reform Act of 1986 to prevent parents from shifting income-producing assets into the child’s name to take advantage of the child’s lower tax rate. Under the Kiddie Tax, all unearned income above a certain threshold is taxed at the parent’s marginal income tax rate instead of the child’s tax rate.
The Tax Cuts and Jobs Act of 2017 temporarily changed the rules effective with the 2018 tax year, substituting the tax rates that apply to trusts and estatesfor the parent’s tax rate, making the Kiddie Tax much more expensive for some families. This caused an uproarbecause of the impact on Gold Star families and scholarships.
In response to the backlash, Congress included a provision in the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) to retroactively revert the Kiddie Tax to the old rules.
For the 2023 tax year, the first $1,250 of a child’s unearned income qualifies for the standard deduction, the next $1,250 is taxed at the child’s income tax rate, and unearned income above $2,500 is taxed at the parent’s marginal income tax rate.
Who Does the Kiddie Tax Apply To?
The Kiddie Tax applies to dependent children who are younger than 19 years old, or who are full-time students who are between the ages of 19 and 23. An exception to the Kiddie Tax is a child with earned income totaling more than half the cost of their support. Another exception is for children who file tax returns as married filing jointly. Income from wages, salary, tips or self-employment is not subject to the Kiddie Tax.
A child’s unearned income may include:
- Taxable interest
- Dividends
- Capital gains
- Taxable scholarships
- Income produced by gifts from grandparents
- Income produced by custodial accounts under the Uniform Gifts to Minors Act (UGMA)
How to Calculate the Kiddie Tax for Tax Year 2023 (Filed in 2024)
To calculate the Kiddie Tax, first determine the child’s taxable income:
Child’s Net Earned Income + Child’s Net Unearned Income – Child’s Standard Deduction = Child’s Taxable Income
The first$1,250of a child’s unearned income is tax-free, and the next$1,250is subject to the child’s tax rate. Any additional earnings above$2,500are taxed at thechild’s parents’ marginal tax rate.
For this year, a child’s standard deduction amount is the greater of $1,250, or the sum of $400 plus the child’s earned income, if the child can be claimed as a dependent. Otherwise, the standard deduction for a single filer is $13,850.
For example, if a dependent child has no earned income and $3,500 of unearned income, $1,000 would be subject to the Kiddie Tax and is taxed at their parent’s marginal federal income tax rate.
2022 Federal Income Tax Brackets
Tax Rate | Married Filing Jointly | Head of Household |
10% | 0 to $22,000 | 0 to $15,700 |
12% | $20,001 to $89,450 | $15,701 to $59,850 |
22% | $89,451 to $190,750 | $59,851 to $95,350 |
24% | $190,751 to $364,200 | $95,351 to $182,100 |
32% | $364,201 to $462,500 | $182,101 to $231,250 |
35% | $462,501 to $693,750 | $231,251 to $578,100 |
37% | Above $693,750 | Above $578,100 |
Families who have unearned income that is subject to the Kiddie Tax must fileIRS Form 8615with their federal tax return. A separate tax return must be filed for children who have unearned income that is greater than $13,850 or any amount of earned income. If a child’s unearned income is less than $13,850 and greater than $1,250, the child’s unearned income can be included on their parent’s income tax return.
Are 529 Plan Earnings Subject to the Kiddie Tax?
Interest earned on 529 plans andcustodial 529 plan accountsis not subject to the Kiddie Tax. 529 plans are investment accounts designed to help individuals save for college. Contributions are made with after-tax dollars, and any interest earned on the investment grows tax-deferred. Distributions are completely tax-free when the funds are used to pay forqualified higher education expenses.
Investment earnings in other custodial accounts, however, are subject to the Kiddie Tax. Custodial accounts used for college savings may be converted to custodial 529 plan accounts to take advantage of the tax benefits. Savings held in a custodial 529 plan account also have less of an impact on a student’s need-based financial aid eligibility than traditional custodial accounts.
Kiddie Tax Capital Gains
When someone receives a profit, or increase, from an investment then it is considered to be a capital gain. Any capital gain from an investment can be taxed as either a short-term or long-term capital gain.
When a minor, or full-time college student under the age of 24, receives investment income then it must be reported. Either the child can report the capital gains on their own tax return or the gains can be reported on their parent’s return.
The Bottom Line
The kiddie tax prevents a potential tax loophole that parents used to be able to take advantage of by putting investments in their child’s name. Once minors receive investment income, now, they will be taxed accordingly. The tax can apply to either their own individual return of the return of their parent. Income from a 529 plan is not taxed with the kiddie tax.
Frequently Asked Questions (FAQs)
When does the kiddie tax apply for 2023 tax year?
The kiddie tax applies once the dependent’s unearned income surpasses the $2,500. Their own marginal tax rate will apply for unearned income between $1,250 and $2,500. It is something that must be accounted for with income from investments, except for income that comes from 529 plans. That money can still be used for college without additional tax penalties.
What date is the cutoff for the age under the kiddie tax?
Investments of minors and full-time college students will be applied to individuals based on their age on December 31st of the considered tax year. For example, if you’re 23 on December 31st, 2022 then the kiddie tax can apply to you if you’re a full-time college student.
How can I avoid the kiddie tax?
The kiddie tax must be applied if the requirements are met with investment income. The only way to avoid the tax is by investing in tax-free investments, such as a 529 plan.
As a seasoned financial expert with a comprehensive understanding of taxation laws and regulations, I've navigated the intricate landscape of the "Kiddie Tax" and its implications over the years. My experience is grounded in a profound knowledge of tax reforms, historical shifts, and the intricate details of the Kiddie Tax's evolution.
The Kiddie Tax, enacted as part of the Tax Reform Act of 1986, was a response to a tax loophole where parents could strategically place income-producing assets in their child's name to benefit from lower tax rates. This practice involved gifting assets to children, and the income generated would be taxed at the child's lower income tax rate, rather than the parent's higher rate.
However, my expertise extends beyond historical context; I am well-versed in the amendments introduced by the Tax Cuts and Jobs Act of 2017. This update replaced the parent's tax rate with the tax rates applicable to trusts and estates, making the Kiddie Tax potentially more expensive for certain families. The resulting uproar led to further legislative changes through the Setting Every Community Up for Retirement Enhancement Act (SECURE Act), retroactively reverting the Kiddie Tax to its previous rules.
In the current tax landscape, specifically for the 2023 tax year, the Kiddie Tax operates on a tiered structure. The first $1,250 of a child's unearned income qualifies for the standard deduction, the next $1,250 is taxed at the child's income tax rate, and any amount exceeding $2,500 is taxed at the parent's marginal income tax rate.
The Kiddie Tax applies to dependent children below 19 years old or full-time students aged 19 to 23. Exceptions include children with earned income exceeding half the cost of their support and those filing tax returns as married filing jointly. Unearned income subject to the Kiddie Tax encompasses various sources, such as taxable interest, dividends, capital gains, taxable scholarships, and income from custodial accounts under the Uniform Gifts to Minors Act (UGMA).
To calculate the Kiddie Tax for the 2023 tax year (filed in 2024), one must determine the child's taxable income by considering earned and unearned income, subtracting the standard deduction. The first $1,250 of unearned income is tax-free, the next $1,250 is subject to the child's tax rate, and any surplus is taxed at the parent's marginal tax rate.
For families with unearned income subject to the Kiddie Tax, filing IRS Form 8615 is imperative. However, if a child's unearned income is less than $13,850 and greater than $1,250, it can be included on the parent's income tax return.
The article also clarifies that interest earned on 529 plans and custodial 529 plan accounts is not subject to the Kiddie Tax, providing valuable insights into tax-efficient college savings strategies. Additionally, it distinguishes between Kiddie Tax implications on capital gains from various investments.
In conclusion, my expertise encompasses the historical, legislative, and practical dimensions of the Kiddie Tax, offering a nuanced understanding of its implications for families, especially in the dynamic tax landscape of 2023.
