The Kiddie Tax is a tax rule in the United States designed to prevent parents from transferring investment income to their children to take advantage of the child’s lower tax bracket. Under the Kiddie Tax, a child’s unearned income, such as interest, dividends, and capital gains, above a certain threshold is taxed at the parent’s marginal tax rate instead of the child’s lower rate.

Key Points About the Kiddie Tax:

1. Purpose:
   • The Kiddie Tax was introduced to prevent families from exploiting the tax system by shifting income-generating assets, like stocks or bonds, to their children who are in lower tax brackets, thus avoiding higher taxes.
2. Who It Applies To:
   • The Kiddie Tax applies to children who meet the following criteria:
     • The child is under 18 years old at the end of the tax year.
     • The child is 18 years old and their earned income does not exceed half of their support for the year.
     • The child is between 19 and 24 years old, a full-time student, and their earned income does not exceed half of their support for the year (excluding scholarships).
   • The rule applies to unearned income only, meaning income from investments or gifts, not income earned from wages or a job.
3. Thresholds and Tax Rates:
   • For the 2023 tax year, the first $1,250 of a child’s unearned income is tax-free, and the next $1,250 is taxed at the child’s tax rate (which is generally lower). Any unearned income above $2,500 is taxed at the parent’s marginal tax rate.
   • These thresholds may be adjusted annually for inflation.
4. Types of Unearned Income:
   • The Kiddie Tax applies to various forms of unearned income, including:
     • Interest from savings accounts, bonds, or other financial instruments.
     • Dividends from stocks or mutual funds.
     • Capital gains from the sale of investments.
     • Income from rental properties or royalties.
     • Trust fund distributions.
5. Tax Filing:
   • Parents can either include the child’s unearned income on their own tax return (using IRS Form 8814) or the child can file a separate tax return (using IRS Form 8615). If the income is reported on the parent’s return, it will be taxed at the parent’s rate.
6. Impact on Financial Planning:
   • The Kiddie Tax can affect decisions regarding gifting assets to children or setting up investment accounts in a child’s name. For example, parents may reconsider the benefits of custodial accounts (such as UGMA/UTMA accounts) if the Kiddie Tax significantly reduces the tax advantages of shifting income to a child.
7. Strategies to Minimize Kiddie Tax:
   • Use 529 Plans: Contributions to 529 college savings plans grow tax-free and are not subject to the Kiddie Tax if used for qualified education expenses.
   • Gifting Strategies: Gifting appreciated assets that the child can hold until they are no longer subject to the Kiddie Tax may help defer taxation.
   • Maximize Earned Income: Encouraging children to earn their own income (which is taxed at their rate) can reduce the impact of the Kiddie Tax on unearned income.

Example of Kiddie Tax Application:

• Scenario: A 17-year-old child has $3,500 in unearned income from dividends and interest. The first $1,250 of this income is tax-free. The next $1,250 is taxed at the child’s tax rate, and the remaining $1,000 is taxed at the parent’s marginal tax rate. If the parents are in a high tax bracket, the tax on this $1,000 could be significant.

Conclusion:

The Kiddie Tax is a tax rule that applies to the unearned income of children and is designed to prevent parents from shifting income to their children to take advantage of lower tax rates. By taxing unearned income above a certain threshold at the parent’s tax rate, the Kiddie Tax ensures that families cannot easily exploit the tax system. Understanding the Kiddie Tax is important for financial planning, especially when considering gifting strategies or setting up investment accounts for children.