Understanding the Kiddie Tax: How it Works and What Parents Need to Know

A few decades ago, high-income families moved investments into their children's names so their investment income would be taxed at a lower rate. As you might suspect, Congress wasn't a fan of this strategy and retaliated with the Kiddie Tax in 1986, which was restructured in 2018 and again in 2019.

For parents who already have custodial accounts for their kids or anticipate having an investment account in the future, it's important to understand the tax impact to optimize your family's tax situation.

What is the Kiddie Tax?

The Kiddie Tax applies to children under 19 years old and full-time students under 24 who don't support themselves financially. The tax is assessed on unearned income – such as interest, dividends, and capital gains - received by children who meet previously noted age requirements. Did your daughter invest in a mutual fund this year? Did her grandparents gift her some stock? Income generated by those investments will be subject to the Kiddie Tax.

How Does the Kiddie Tax Work?

Under the 2023 Kiddie Tax rules, the first $1,250 of a child's unearned income is tax-free, the next $1,250 is taxed at the child's income tax rate, and any unearned income above $2,500 is subject to the Kiddie Tax. The income above $2,500 is taxed at the parent's tax rate, generally higher than the child's rate. The exempted amount increases over time due to inflation. For the 2024 tax year, the kiddie tax threshold has increased to $2,600.

Implications for Parents:

Parents should carefully consider the implications of the Kiddie Tax when planning their family's finances and investments. Strategies to minimize the impact of the Kiddie Tax may include:

1. Choose tax-efficient investment options: Parents can opt for investments that generate minimal unearned income, such as growth stocks that don't pay dividends or exchange-traded funds that don't generate capital gains. Investment selection is key in managing unearned income.
   
   
2. Utilize tax-loss harvesting: When an investment has lost value, the position can be sold, and the loss can be used to offset future gains.
   
   
3. Contribute to tax-advantaged accounts: Funding tax-advantaged accounts such as 529 plans can help reduce the impact of the Kiddie Tax, as investment earnings within these accounts grow tax-deferred and potentially tax-free if used for qualified education expenses. If the child has earned income, they may be eligible to contribute to a Roth IRA for a lifetime of tax-free growth.
   
   
4. Seek professional advice: Tax planning can be complex, especially concerning the Kiddie Tax. Consulting with a qualified tax advisor or financial planner can help parents navigate the intricacies of tax law and develop strategies to optimize their family's tax situation.

Real Life

How might this play out in the real world? Here's an example. Let's assume Jane is 15 years old, doesn't work, and has $7,100 in dividends in 2023. The first $1,250 is not taxed. That leaves $5,850 in net unearned income. The next $1,250 is taxed at 10 percent ($125 tax bill), and the remaining $4,600 is subject to the Kiddie Tax and, therefore, taxed at the parent's tax bracket. If the parents are in a 24% marginal tax bracket, the remaining $4,600 is taxed at 24% ($1,104). The total tax due on Jane's investment income would be $1,229.

The Kiddie Tax also applies to distributions received from an Inherited IRA account. If it's an option, bequeath to children Roth IRAs instead of Traditional IRAs to minimize the tax impact.

Tax Filing

Depending on the broader tax situation, the Kiddie Tax can be reported on either the child's tax return or the parents. Generally, if your child has unearned income greater than $1,250 or earned income over $13,850, they must file a separate tax return. However, this can get complicated, so it's best to consult a tax advisor to determine the most beneficial method for reporting the income.

Conclusion

The Kiddie Tax is an important consideration for parents with children who have unearned income. By understanding how the Kiddie Tax works and implementing appropriate tax planning strategies, parents can minimize their family's tax liability while ensuring compliance with IRS regulations.

Consulting with a tax professional or financial advisor is recommended to develop a personalized tax strategy that considers the Kiddie Tax and maximizes tax efficiency for the entire family.

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