Article Highlights:
- Why Kiddie Tax
- Unearned Income
- Exceptions
- Understanding Kiddie Tax Rules
- Strategies for Children with Earned Income
- Parental Election to Include Child's Unearned Income
- Strategies to Avoid the Kiddie Tax
The U.S. Congress enacted the "Kiddie Tax" in 1986 to try and stop high-income parents from taking advantage of tax benefits by passing on their investment income to their children, who usually fall into lower tax categories. The Kiddie Tax effectively imposes higher tax rates to certain children's unearned income, even though it is not specifically called such in the tax statute. This page explores the nuances of the Kiddie Tax, including who is affected, how it is governed, and how to mitigate its effects.
If a kid is not self-supporting, the Kiddie Tax is levied on their unearned income if they are under the age of 19 or 24 for full-time students. Dividends, interest, and capital gains are examples of unearned income, although they are not the only ones. It's vital to remember that the Kiddie Tax regulations do not apply to married children or children whose parents are deceased at the conclusion of the tax year; in these cases, the child's income is taxed at their own rate.
Exceptions to the Rule
The Kiddie Tax has some exclusions that prevent a child's income from being taxed at the parent's rate. For example, a child's unearned income is exempt from the Kiddie Tax if it is less than a particular level, which is $1,300 for 2024. Furthermore, earned income—that is, money from work—is subject to standard deduction and taxed at the child's rate, which considerably lowers the tax burden for working children.
Understanding Kiddie Tax Rules
In 2024, a child's unearned income is taxed at the child's rate on the first $1,300, and not at all on the subsequent $1,300. Unearned income above $2,600 is subject to taxation at the greater of the parent's or child's rates, with the maximum rate being 37%. Every year, these levels are updated to account for inflation.
Strategies for Children with Earned Income
Youngsters who have earned income—that is, money from employment—can use the standard deduction to reduce their taxable income. In 2024, a child's earnings up to a standard deduction of $14,600 are tax-free for single individuals. Moreover, kids can fund a regular IRA with contributions up to $7,000 for 2024 or the lesser of their earned income, which could raise their tax-free amount to $21,600. To promote retirement savings, parents or grandparents may think about giving their kid the IRA contribution as a gift if their child is unwilling to give their hard-earned money.
If you contribute to an IRA, you should also think about opening a Roth IRA, which offers tax-free income in retirement. The downside of a Roth is that the contribution isn't tax deductible, so a child's tax-free earnings would be limited to the standard deduction amount. Even so, the tax the child would pay on the nondeductible contribution would likely only be at the 10% or 12% rate, which is probably lower than what the child's tax rate will be when they retire.
Parental Election to Include Child's Unearned Income
Rather than having their kid file a separate tax return, parents may find it advantageous in some situations to put their child's interest and dividend income on their own tax return. This choice is only possible if the parents fulfill specific requirements, such filing a combined return, and the child's income is limited to interest and dividends. The child won't have to file their own return in these circumstances, but it's important to carefully evaluate which approach will result in the lowest amount of tax on the unearned income.
Strategies to Avoid the Kiddie Tax
Parents and guardians can use a number of tactics to lessen the effects of the Kiddie Tax. Investing in dividend-paying growth companies or mutual funds is one way to postpone the recognition of income until the child is out of the Kiddie Tax. Another tactic is to make contributions to a 529 college savings plan, which essentially avoids the Kiddie Tax by providing tax-free growth and withdrawals for approved educational costs.
Families that are preparing their investment and tax plans should take the Kiddie Tax into account. To minimize the Kiddie Tax's effects and optimize the financial security of both parents and children, it is essential to comprehend its regulations and exclusions. Families may manage the complexity of the Kiddie Tax and make sure their investment income is treated as favorably as possible by using strategic planning and utilizing available tax incentives.
For assistance with handling and preparing for the Kiddie Tax, get in touch with this office.
