People with large assets often think of ways to reduce their tax burden. In the past, a popular idea for parents was to transfer assets to young children, who typically faced a lower tax rate on investment income. As a result, wealthy parents can effectively protect themselves from taxes on investments.
Enter kiddie tax. First introduced through the Tax Reform Act of 1986, the kiddie tax was intended to discourage wealthy individuals from holding income-producing property in the name of their children simply to avoid paying taxes. And kiddie taxes are a relatively simple way to curb this undesirable practice.
And kiddie tax thresholds are on the lower end, meaning it doesn’t take long to trigger an additional tax charge. But if you understand what the kiddie tax is and how it works, keeping an eye on planning can help reduce your child’s tax expense.
What is kiddie tax?
The kiddie tax is a tax that the IRS levies children at their parents’ tax rate when they make up a specified amount in unearned income. “Children” are usually children under the age of 18 or full-time students under the age of 24, and “unearned income” is essentially passive income, which is money they receive from property they haven’t worked for. such as rental properties, stocks and bonds. It has nothing to do with actively earned income such as wages or any other compensation from the job.
The kiddie tax closed a previous tax loophole, allowing parents to pass on large blocks of income-producing assets to their children. This allowed the wealthy parents of minors to pay far less in taxes than they otherwise would have owed.
When the kiddie tax applies
A child must meet certain requirements to apply for the kiddie tax:
Unearned income that exceeds the child’s tax rate limit ($2,300 in 2022) has at least one surviving parent at the end of the tax-filing period to be required to file a tax return (and not file jointly). be under 18 at the end of the tax year, 18 without a parent providing more than half of their support for the year, or more than half of their parent’s support for the year at the end of the tax year 19 between 24 years of age
The IRS isn’t making life any easier for us, but figuring out kiddie taxes is straightforward in most cases.
How does the kiddie tax work?
The kiddie tax applies to ordinary unearned income such as interest, dividends, rent and royalties. Children only have to pay if they earn more than a specified amount, and even then, they pay their tax rate up to a certain income level. But if they earn too much, they fall into the same tax bracket as their parents.
2021-2022 Kiddie Tax Table
Tax Type2021 Unearned Income 2022 Unearned Income Tax Table RateChildren’s Standard Deduction $1,100 or Less$1,150 or Less Child Tax Range $1,101 to $2,200$1,151 to $2,300 Taxed at Child’s Tax RateKiddi Tax Limit Over $2,200 Over $2,300 Parent- taxed at father’s tax rate
A child’s standard deduction for 2022, the tax return you’ll file in 2023, is $1,150 ($1,100 in 2021), so if they make that amount or less, they don’t pay taxes. The child pays taxes at his or her marginal tax rate at unearned income levels of $1,151 to $2,300 ($1,101 to $2,200 in 2011). To find their marginal tax rate, use the typical IRS single-filer table for the tax year you’re filing for.
If they earn more than the child’s tax rate limit, the kiddie tax kicks in. At that point, they pay tax at their parents’ tax rate. This can be especially costly if the child has a large amount of stock or has high-income parents.
Families earning well in the six digits are most at risk of facing kiddie tax, although it is not the worst problem.
How to Calculate Kiddie Tax
Calculating kiddie tax is fairly easy if you know the key limits and tax rates for each income level. First, gather all the documents related to unearned income, or money earned without active effort, and add it all up. Then apply the formula.
Kiddie Tax Formula
Depending on how much unearned income your child has, kiddie tax may require you to do several different calculations.
Unearned standard deduction amount = $0 child’s taxable amount in taxes x child’s marginal tax rate remaining unearned income x parent’s marginal tax rate Add the amount for Steps 2 and 3
You can find the child’s marginal tax rate by checking the IRS tables. For most kids, this is going to be the rate for singles, and unless they have a lucrative job for their age in addition to unearned income, it’s probably 10% or 12%. The parent’s marginal tax rate is the highest rate you can pay for your own taxes, also available in the IRS tables.
kiddie tax example
In 2022, Chet, a high-school student, earned $8,400 in unearned income from interest and dividend payments. This is his only income for the year. This puts him in the 10% tax bracket.
His parents, who file jointly, make $500,000 a year as a couple. As such, their marginal tax rate is 35%. Based on the kiddie tax formula, his tax calculation looks like this:
$1,150 (2022 unearned standard deduction) tax-free $1,150 ($2,300 child tax limit – $1,150 standard deduction) x 10% = $115 $6,100 ($8,400 – $1,150 – 1,150) x 35% = $2,135$115 + $2,135 = $2,250
On Chet’s first $1,150 of unearned income, there are no taxes (this is the standard deduction each child receives).
On Chet’s next $1,150 of unearned income, income tax is applied at Chet’s marginal tax rate – 10%. The family owes $115 ($1,150 x 10%).
On Chet’s final $6,100 ($8,400 – $2,300) of unearned income, the kiddie tax applies at his parents’ marginal tax rate of 35%. If you add up the taxes Chet should pay based on his tax bracket (Step 2) and taxes based on his parents’ tax bracket (Step 3), the family totals $2,250 ($115 There is a tax owed of income tax + $2,135 kidi (tax).
How to Avoid the Kiddie Tax
There are a few ways to avoid kiddie taxes, but they all require some planning:
Limit your child’s investment income. If you give assets to your child — such as stocks or bonds — that produce more than the child’s unearned income tax limit, kiddie taxes will come into play if the estate is in a taxable account. Use tax-deferred or tax-exempt accounts. You can use tax-deferred or exempt accounts like 529 plans and Roth IRAs to avoid kiddie taxes. 529 plans offer a tax shield as you earn income, while Roth IRAs are permanently tax-free, provided you meet the required holding period of five years. Consider tax-free investment options. If you can’t avoid opening a taxable account for your child, take a look at municipal securities that generate tax-free income. If avoiding kiddie taxes is the end goal, municipal debt, such as bonds issued by state and local governments, may be a good option.
Kiddie Tax FAQs
Kiddie taxes can be difficult to navigate. But it is certainly possible to learn the basics. These are some of the most frequently asked questions about kiddie tax.
What is the purpose of the kiddie tax?
The purpose of the kiddie tax is to ensure that high-income households pay their fair share of investment-related taxes. A popular strategy employed prior to the Tax Reform Act of 1986 was to transfer large blocks of valuable stock to children with the expectation that any real gains would be taxed at the child’s lower tax rate.
The kiddie tax effectively ensures that transferring stock to the child owner of the same family will not reduce the total tax owed. In many cases, it can even increase the family’s tax bill.
Does my child need to file an income tax return?
This depends on several factors, including the source and nature of the income and whether they withheld taxes. There are different rules around earned and unearned income because the IRS sees the two as fundamentally different: The former requires active effort, while the latter usually results in investments on autopilot.
As such, your child must file a tax return for 2022 if any of the following apply:
Unearned income exceeds the child’s standard deduction for the year ($1,150 for 2022) Earned income exceeds the regular standard deduction ($12,950 for 2022) The combination of both unearned and earned income exceeds 1) $1,150 or 2. ) Total Earned Income up to $12,550 plus $400 for 2022
Note that these amounts change annually, so stay up to date on the relevant filing thresholds for your child. And if you’re filing for previous years, look at those thresholds as well.
But that doesn’t mean that your child has to mandatorily file their own tax return. If they only have unearned income, there is an option to report your child’s unearned income on your tax return if it is $11,500 or less ($11,000 in 2021).
Also note that even though filing a tax return is not explicitly required for your child, it may be doable if your child has income tax withheld from his or her earnings throughout the year. It also makes sense to file a tax return if your child qualifies for the Earned Income Credit.
If your child has an unusual situation, check your accountant or IRS website to determine whether a separate tax return is necessary. Needless to say, the answer to this question is not as simple as one would expect.
Does kiddie tax apply to 529 plan income?
Fortunately, the kiddie tax does not apply to 529 plan income. Those plans are designed to help families save for the rising cost of college. And in some circumstances, they offer state tax deductions in exchange for annual contributions.
A 529 plan account is a tax-deferred account. This means you don’t pay taxes on investment growth or earnings until you withdraw them. Current account income is not included in your annual tax return.
As long as your child eventually uses 529 plan assets for qualified education expenses, kiddie tax isn’t something you need to worry about in this context.
Whether or not kiddie tax is a worthwhile policy depends on your point of view. If you have to pay kiddie tax, it’s best to think of it as a tax on passive income — money they earned without any active effort.
Regardless, before making any declarative statements about kiddie tax exposure, it is prudent to consider all sources of income, both earned and unearned. You may owe more or less than you think.