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What Is the Kiddie Tax

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People with sizable assets often think about ways to minimize their tax burden. In the past, one popular idea for parents had been to shift assets to young children, who typically faced a lower tax rate on investment income. As a result, wealthy parents could effectively shield themselves from taxes on investments. 

Enter the kiddie tax. First introduced through the Tax Reform Act of 1986, the kiddie tax’s purpose was to discourage wealthy individuals from placing income-producing property in their children’s names solely to avoid paying taxes. And the kiddie tax is a relatively simple way of curbing this undesirable practice. 

And kiddie tax thresholds tend to be on the lower end, which means it doesn’t take much to trigger additional tax charges. But an eye toward planning can help minimize your child’s tax expense if you understand what the kiddie tax is and how it works. 

What Is the Kiddie Tax?

The kiddie tax is a tax the IRS charges kids at their parents’ tax rate when they make over a specified amount in unearned income. “Kids” are usually children under 18 or full-time students under 24, and “unearned income” is essentially passive income, which is money they get from assets they didn’t work for, like rental property, stocks, and bonds. It has nothing to do with actively earned income like wages or any other compensation from a job. 

The kiddie tax closed a previous tax loophole that allowed parents to give their children large blocks of income-producing property. That allowed wealthy parents of minors to pay much less in taxes than they otherwise would have owed. 

When the Kiddie Tax Applies

A child must meet certain requirements for the kiddie tax to apply:

  • Have more than the child’s tax rate threshold ($2,300 in 2022) in unearned income
  • Have at least one living parent at the end of the tax-filing period 
  • Be required to file a tax return (and not file jointly)
  • Be under 18 at the end of the tax year, 18 at the end of the tax year without the parents providing more than half of their support for the year, or between the ages of 19 and 24 without providing more than half their parents’ support for the year 

The IRS isn’t making life easy for us, but figuring the kiddie tax is straightforward in most cases. 

How the Kiddie Tax Works

The kiddie tax applies to common unearned income like interest, dividends, rents, and royalties. Kids only have to pay if they make over a specified amount, and even then, they pay at their own tax rate up to a certain income level. But if they make too much, they fall into the same tax bracket as their parents. 

2021-2022 Kiddie Tax Table

Tax Type 2021 Unearned Income 2022 Unearned Income Tax Table Rate
Kid’s standard deduction  $1,100 or less $1,150 or less Taxed at 0%
Child’s tax threshold $1,101 to $2,200 $1,151 to $2,300 Taxed at child’s tax rate
Kiddie tax threshold Over $2,200 Over $2,300 Taxed at parents’ tax rate

A child’s standard deduction for 2022, the tax return you’ll submit in 2023, is $1,150 ($1,100 in 2021), so if they make that amount or less, they don’t pay taxes at all. The child pays taxes at their own marginal tax rate on unearned income levels of $1,151 to $2,300 ($1,101 to $2,200 in 2021). To find their marginal tax rate, use the general IRS single-filer table for the tax year you’re filing for. 

If they make more than the child’s tax rate threshold, the kiddie tax kicks in. At that point, they pay taxes at their parents’ tax rate. It can be particularly costly if the child owns a large amount of stock or has high-earning parents.

Families who earn well into the six figures are at highest risk of facing the kiddie tax, though that’s not the worst problem to have.

How to Calculate the Kiddie Tax

Calculating the kiddie tax is easy enough if you know the key thresholds and tax rates for each income tier. First, gather all documents related to unearned income, or money earned without active effort, and add it all up. Then apply the formula.

Kiddie Tax  Formula 

The kiddie tax may require you to make several separate calculations, depending on how much unearned income your child has.  

  1. Unearned standard deduction amount = $0 in taxes 
  2. Child’s tax rate-eligible amount x child’s marginal tax rate 
  3. Rest of unearned income x parents’ marginal tax rate 
  4. Add amounts for Steps 2 and 3

You get the child’s marginal tax rate by checking the IRS tables. For most kids, it’s going to be the rate for singles, and unless they have a rather lucrative job for their age in addition to unearned income, it’s probably 10% or 12%. The parents’ marginal tax rate is the highest rate you pay for your own taxes, which is also available in the IRS tables.

Kiddie Tax Example 

In 2022, Chet, a high-school student, accrues $8,400 in unearned income from interest and dividend payments. It’s his only income for the year. That puts him in the 10% tax bracket. 

His parents, who file jointly, earn $500,000 annually as a couple. As such, their marginal tax rate is 35%. Based on the kiddie tax formula, his tax calculations look like this:

  1. $1,150 (2022 unearned standard deduction) tax-free
  2. $1,150 ($2,300 child’s tax threshold – $1,150 standard deduction) x 10% = $115 
  3. $6,100 ($8,400 – $1,150 – 1,150) x 35% = $2,135
  4. $115 + $2,135 = $2,250

On Chet’s first $1,150 of unearned income, there is no tax (it’s the standard deduction every kid gets to take).

On Chet’s next $1,150 of unearned income, income tax kicks in 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, kiddie tax kicks in at his parents’ marginal tax rate of 35%. If you add the taxes Chet should pay based on his tax bracket (Step 2) and the taxes he should pay based on his parents’ tax bracket (Step 3), the family owes a total tax of $2,250 ($115 income tax + $2,135 kiddie tax).

How to Avoid the Kiddie Tax

There are a few ways to avoid the kiddie tax, but all of them require some planning:

  • Limit Your Child’s Investment Income. If you give your child property — like stocks or bonds — that produces more than the child’s unearned income tax threshold, kiddie tax will come into play if the property is in a taxable account. 
  • Make Use of Tax-Deferred or Tax-Exempt Accounts. You can use tax-deferred or -exempt accounts like 529 plans and Roth IRAs to avoid the kiddie tax. The 529 plans provide a tax shield as they earn income, while Roth IRAs are permanently tax-exempt provided you meet the five-year required holding period. 
  • Consider Tax-Free Investment Options. If you can’t avoid opening a taxable account for your child, take a look at holding municipal securities that produce tax-exempt income. Municipal debt, like bonds issued by state and local governments, might be a good choice if avoiding kiddie tax is the ultimate goal. 

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Kiddie Tax FAQs

The kiddie tax can be tricky to navigate. But it’s certainly possible to learn the basics. These are some of the most commonly asked questions surrounding the kiddie tax.

What Is the Kiddie Tax’s Purpose?

The kiddie tax’s purpose is to ensure that higher-earning families pay their fair share of investment-related taxes. A popular strategy employed before the Tax Reform Act of 1986 was to transfer large blocks of appreciated stock to children with the expectation that any realized gains would be taxed at the child’s lower tax rate. 

The kiddie tax effectively ensures that transferring stock to a child owner within the same family will not reduce total tax owed. In many cases, it may even increase a family’s tax bill. 

Does My Child Need to File an Income Tax Return?

That depends on several factors, including the source and nature of the income and whether they had taxes withheld. There are separate rules around earned and unearned income since the IRS sees the two as fundamentally different: the former requires active effort, while the latter is typically a result of investments on autopilot.

As such, your child must file a tax return for 2022 if any of the following apply:

  • Unearned income exceeds 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 is more than the larger of 1) $1,150 or 2) total earned income up to $12,550 plus $400 for 2022

Note that these amounts change yearly, so stay up to date on the relevant filing thresholds for your child. And if you’re filing for prior years, look up those thresholds too.

But that doesn’t mean your child necessarily has to file their own tax return. If they only have unearned income, there’s an option to report your child’s unearned income on your tax return if it’s $11,500 or less ($11,000 in 2021).

Also note that even if it’s not explicitly necessary to file a tax return for your child, it might still be worth doing if your child had income tax withheld from their earnings throughout the year. Filing a tax return can also make sense if your child qualifies for the earned income credit.

If your child has an unusual situation, refer to your accountant or the IRS website to determine if a separate tax return is necessary. Needless to say, the answer to this question isn’t as simple as one would hope.

Does the Kiddie Tax Apply to 529 Plan Earnings?

Fortunately, the kiddie tax does not apply to 529 plan earnings. Those plans are designed to help families save for the ever-increasing costs 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. That means you don’t pay taxes on investment growth or earnings until you withdraw them. Ongoing account earnings don’t figure into your annual tax return. 

As long as your child ultimately uses 529 plan assets for qualified education expenses, the kiddie tax isn’t something you need to worry about in this context. 

Final Word

Whether the kiddie tax is a worthwhile policy depends on your perspective. If you have to pay kiddie tax, it’s best to think of it as a tax on passive income — money they earned with no active effort. 

Regardless, it’s prudent to consider all sources of income, both earned and unearned, before making any declarative statements about kiddie tax exposure. You may owe more or less than you think.

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