Many of us have minor children and a surprising number of those children have income from a variety of sources. It is no surprise that the IRS wants to capture this income and subject it to taxation, just as it does for our income as adults. A child’s earned income is subject to income and payroll taxes, just as an adult’s income would be, and the “kiddie tax” does not apply to such earned income.
The income which is the focus of the “kiddie tax” is investment or unearned income received by children under the age of 19 and may include unearned income received by children over 18 who are full-time students. Unearned income is broadly defined to include not only dividends, interest and capital gains but also would include distributions from inherited IRAs, Social Security survivor’s benefits, and other types of unearned income. The purpose of this tax is to prevent parents from reducing their tax obligations by shifting income to their children, who are typically subject to a much lower income tax bracket and rate, by placing investments in their children’s names.
When and how does this tax work? Where a child has unearned income in excess of the applicable threshold – $2,100 for 2017 – the unearned income above that amount will be taxed at the parent’s highest marginal income tax rate. With the highest income tax rate currently at 39.6 percent, you can see where the tax on a child’s unearned income could be burdensome and unwelcome. The child benefits from an exemption of the first $1,050 of income and the next $1,050 of the unearned income will be taxed at the child’s rate. These two items together comprise the $2,100 threshold noted above.
You may include a child’s income on your (the parent’s) tax return if a number of conditions are met, including where the only income for the child was unearned income . More commonly, a separate tax return is filed for the child as this will potentially result in lower overall tax than inclusion on the parent’s return will accomplish. Interestingly, the parent information required on the child’s tax return where the “kiddie tax” applies is that of the primary taxpayer (first listed for married couples), the custodial parent for divorced persons, or the parent with the highest income where the parents are married filing separately or have never been married. This may impact the rate charged on unearned income above the threshold where, for example, a custodial parent has a lower tax bracket than a divorced parent without custody.
Of course, not all investments generate significant income and so many investments or income sources owned by a child will not trigger the “kiddie tax” so long as items such as dividends and gains are low. Your financial adviser can assist with recommendation for investments that will help you avoid or minimize this tax by keeping unearned income below the threshold. Note in this connection that a section 529 plan established for a child’s education may have substantial unearned income but this type of holding will not be subject to the” kiddie tax” – or any income tax – where the parent is the owner and there are no distributions. Tax on distributions from a section 529 plan will occur only where those distributions are used for non-qualified expenses.
Where there is a capital loss in the child’s investment accounts for a particular year, the loss may be set off against current capital gains or carried forward just as is the case for adult taxpayers. However, that loss (if any) is attributable to the child and may not be used by the parent.
George Chamberlin & Mentor RIA Consulting © 2017
[i] Unearned income received by children between ages 19 and 23 who are full time students and have earned income less than half the cost of their support for the year will be subjected to the kiddie tax to the extent it exceeds the threshold.
[ii] Other requirements for including the child’s unearned income on your return include that there was no federal withholding or estimated tax payments for the child for the year, the child is not filing a joint return but is required to file a return, as well as the age limits mentioned above.