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Kiddie Tax Class 101

December 2014
by George W. Climer III, CFP®

See Kiddie Tax Update, dated January 2018

Just what is the Kiddie Tax, and how does it affect you and your children? Several years ago, we wrote an article about the Kiddie Tax. The American Taxpayer Relief Act of 2012 (ATRA) and its accompanying higher tax rates have prompted us to post a Kiddie Tax refresher.

The Kiddie Tax was initially introduced in the Tax Reform Act of 1986 as a tax on a child's unearned income. Previously, some wealthy parents sheltered investment income by transferring investment assets into investment accounts owned by their minor children. This practice shifted unearned income from the wealthy parents' higher tax bracket to their child's lower tax bracket. First focused on the unearned income of children under 14, Congress later expanded the tax to include children under 19 and those between 19 and 24 who can be classified as dependent full-time students.

To understand the Kiddie Tax, it is important first to be familiar with a couple of U.S. tax system characteristics. It is a progressive tax system, and it draws a distinction between unearned vs. earned Income. Progressive tax rates (as compared to flat or regressive tax rates) tax every taxpayer's first dollar of income at same the lowest rate. However, taxpayers then move up through higher marginal tax brackets as they have more income. ATRA increased the highest marginal income tax bracket from 35% to 39.6% and the highest marginal long-term capital gains tax from 15% to 20%. ATRA also implemented a new Net Investment Income Tax on unearned income for wealthy taxpayers. The Kiddie Tax is designed to limit the transfer of investment income from these higher marginal tax brackets to lower marginal brackets.

The Kiddie Tax does this by focusing on a child's unearned income. Think of unearned income as the income paid from investments such as interest, dividends and capital gains. Compare this income to earned income from activities such as a paper route or life guarding.

What is Unearned Income? What is Earned Income?
  • Interest
  • Dividends
  • Capital Gains
  • Income from rental property
  • Salaries, bonuses
  • Wages
  • Commission, tips
  • Self-Employment net earnings

Specifically, the Kiddie Tax becomes an issue when a child's unearned income exceeds $2,100. Let's take a look at the 2015 Kiddie Tax thresholds and respective tax rates, and a couple of examples to illustrate its impact:

Unearned Income Level Tax Rate
$0 – $1,050 0% (standard dependent deduction)
$1,050 – $2,100 10% (taxed at child's low tax rate)
$2,100 + Taxed at the parents' marginal tax rate (either on the child's return, using Form 8615, or on the parents' return, using Form 8814).

Example 1
Twelve-year-old Penelope Climer has $2,500 of interest income from her Bragg custodial account. How might she and her parents be affected?

Unearned Income Taxes
First $1,050 $0 tax (standard dependent deduction)
Next $1,050 $105 tax (taxed at child's 10% tax rate)
Kiddie Tax on balance of unearned income (balance = $400) $112 tax (assuming parental marginal tax rate of 28%)
$2,500 total income $217 of taxes due (Paid either by filing a return for Penelope or adding to her parents' return.)

Had all of the income been taxed at Penelope's 10% marginal rate, assuming there was no Kiddie Tax, she would have paid $140, versus the above $217 Kiddie Tax amount. Conversely, had all of the above income been taxed at Penelope's parents' 28% marginal tax rate, they would have paid taxes of $700 on Penelope's behalf, versus the above $217.

Example 2
Michael Daly, a hard-working Wake Forest sophomore, has $5,000 of interest income from his investment account and $10,000 of W-2 income. How does the Kiddie Tax apply for Michael and his parents?

Unearned Income Taxes
First $1,050 $0 tax (standard dependent deduction)
Next $1,050 $105 tax (taxed at child's 10% tax rate)
Kiddie Tax on balance of unearned income (balance = $2,900) $812 tax (assuming parental marginal tax rate of 28%)
Earned Income  
$10,000 of W-2 income $1,000 (taxed at child's 10% tax rate)
$15,000 total income $1,917 of taxes due (Michael must file a return because of the higher overall income . . . beyond article scope.)

If Michael were 25 in this example and therefore not subject to the Kiddie Tax due to his age, he would have paid $1,395, versus the above $1,917. If all of Michael's income had been taxed to his parents' 28% bracket, they would have paid $4,200 of taxes on his behalf.

While the Kiddie Tax was enacted to prevent large amounts of income shifting from parent to child (or grandparent to grandchild), remember that the first $2,100 of a child's unearned income is still taxed at more favorable rates. Therefore, limited income shifting may still make sense, for example:

  • Transfer low-basis stock that you want to sell to your children. You will still pay your tax rate on gains above $2,100, but the first $2,100 could be taxed at a lower rate than you could have experienced had you sold the stock yourself.
  • Transfer low-basis stock to your children that you do not intend for them to immediately sell. The idea is to hold the securities until the child is out on his own and no longer a dependent. At that point, these securities can be liquidated and taxed at the now independent young adult's capital gains rate, which may be lower than your rate. In the meantime, up to $2,100 of the annual dividends from the stock would be subject to lower rates than you would otherwise pay.

There are ways to minimize the negative Kiddie Tax impact when transferring wealth to children, or when trying to establish investments for minors.

  • Fund a 529 Plan for the child's college education, instead of a custodial account. The income earned annually on the balance is not subject to income tax and funds distributed for qualified college expenses are not subject to tax (see our 529 Plan article for more benefits of 529 Plans).
  • Invest the child's money in a Roth IRA to the extent he or she has earned income. Note, there is no rule stating who can contribute to the Roth on behalf of the child, only that the amount contributed cannot exceed the lesser of
    • the contribution limit for that year, which is $5,500 for 2014 and 2015, or
    • the amount the child actually earned and reported on their return.
  • Gift them investments that appreciate in value over time, but that don't generate much or any unearned income until the investments are sold. Ideally the investments would be sold when the children are no longer eligible for the Kiddie Tax. Of course, all of following examples should be part of a logical investment plan:
    • Buy them growth stocks or mutual funds of companies that reinvest profits for future growth, rather than paying out taxable dividends.
    • Buy U.S. Savings Bonds in their names and defer interest payments until after the age restriction has passed. Interest would then be taxed at their rate.
    • Buy municipal bonds that mature after your child is subject to the Kiddie Tax. Municipal bonds are exempt from federal income tax. If the bonds are later sold at a profit, they will be taxed at the child's capital gains rate.

In summary, while the Kiddie Tax was enacted to limit income shifting, there could be other wealth transfer strategies appropriate for your specific situation. We recognize that strategies appropriate for one client may not be appropriate for others. Please call or come by to discuss planning for you and your family. As always, thank you for choosing Bragg Financial Advisors.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.