Kiddie Tax: How to Minimize a Child's Income Tax
If you have a child under the age of 18 or under the age of 24 and a full-time student, your family needs to be aware of the kiddie tax.
Technically called a tax on a child’s investment or other unearned income, the kiddie tax could potentially result in a much higher tax rate than you’d otherwise expect your child to pay.
The kiddie tax is part of the federal income tax and it is extremely complex.
If you think your family may be subject to the kiddie tax, you’re likely best served by consulting a tax professional.
They may even be able to help you avoid the kiddie tax by restructuring your family’s investments.
Before you consult a tax professional, here’s some basic general information about the kiddie tax and how it works.
Keep in mind:
The rules are very complex and not all rules are discussed below.
If you aren’t subject to the kiddie tax, you may not need to consult a tax professional in regards to this issue.
What Is the Kiddie Tax?
The kiddie tax is a type of tax that was created to prevent parents from avoiding taxes by shifting investments to their children.
Before the kiddie tax existed
Parents could transfer investments to their children who would pay a much lower tax rate on the gains.
This makes sense because children usually have very little income to report, especially if they don’t have a job yet.
After the kiddie tax was passed
Children with unearned income from investments above a certain amount usually had to start paying higher tax rates on their income.
While the kiddie tax was created to prevent tax avoidance, it has other impacts, too.
Parents that want to teach their children to invest at an early age can get frustrated by the kiddie tax. If a child is legitimately investing their own money, they may be punished by this quirk in the tax code.
There are ways to get around the kiddie tax, but they aren’t ideal.
It’s best to learn about the kiddie tax and how it works. Then, you can decide how to best help your children avoid this tax.
What Is the Current Kiddie Tax Rate?
The kiddie tax rates have undergone recent changes.
The Tax Cuts and Jobs Act (TCJA) which was passed in December 2017.
Before the recent tax law changes, the kiddie tax charged children tax on unearned income above a certain level at the tax rates their guardians paid on their tax returns.
The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE ACT) repealed the changed made by the TCJA in the Kiddie Tax. The SECURE ACT reinstated the Kidde Tax as it was before 2018. This change is mandatory for 2020 and later.
Under these rules, children pay tax at their own income tax rate on unearned income they receive up to a threshold amount - for 2020, the threshold is $2,200. All unearned income that kids receive above the threshold is taxed at their parent's highest income tax rate, if higher than the child's rate. That rate can be as high as 37%, compared to the 10% rate that most children would be paying.
Unfortunately, these rates increase quickly, unlike a parent’s tax rates.
2021 kiddie tax rates
For the tax year 2021, the tax brackets for taxable income are:
Kiddie Tax Rates
|Tax Rate||Married, filing jointly||Head of household|
|10%||0 to $19,750||0 to $14,100|
|12%||$19,751 to $80,250||$14,101 to $53,700|
|22%||$80,251 to $171,050||$53,701 to $85,550|
|24%||$171,051 to $326,600||$85,551 to $163,300|
|32%||$326,601 to $414,700||$163,301 to $207,350|
|35%||$414,701 to $622,050||$207,351 to $518,400|
|37%||all over $622,050||all over $518,400|
The tax rates for long-term gains and qualified dividends are:
- 0% for amounts over $0 but not over $2,650
- 15% for amounts over $2,600 but not over $13,150
- 20% for amounts above $13,150
Who Does the Kiddie Tax Apply To?
Currently, the kiddie tax applies to children who have more than $2,200 of unearned income in the 2021 tax year. Under the Kiddie Tax rule, the first $1,100 of a child’s unearned income qualifies for the standard deduction. The next $1,100 is taxed at the child’s income tax rate. A child (or young adult’s) unearned income beyond $2,200 is taxed at the parent’s normal tax bracket.
You file tax returns for the 2021 tax year in early 2022.
Unearned income includes things like interest and dividends.
The tax is calculated on IRS Form 8615 Tax for Certain Children Who Have Unearned Income.
According to the IRS, you have to file this form if all of the following conditions are met for the 2020 tax year:
- Your unearned income was more than $2,200
- You meet one of the following age requirements:
- You were under age 18 at the end of the tax year,
- You were age 18 at the end of the tax year and you didn't have earned income that was more than half of your support, or
- You were a full-time student at least age 19 and under age 24 at the end of the tax year and you didn't have earned income that was more than half of your support
- At least one of your parents was alive at the end of the tax year
- You're required to file a tax return for the tax year
- You don't file a joint return for the tax year
As you can see, there are many kiddie tax rules that must be met to have to file this form.
Ways to Avoid Paying or Minimize the Kiddie Tax
Just because the kiddie tax exists doesn’t mean you or your family should pay it. If you plan smart, you may be able to avoid it.
As with all taxes, you should do your best to legally minimize the amount of tax you owe.
That doesn’t mean you should do anything illegal such as not reporting income, though.
Thankfully, there are ways to legally avoid paying or to minimize paying the kiddie tax.
1. Keep investment income low for children
The easiest way to avoid the kiddie tax is to keep investment and other unearned income low for children.
The most common types of unearned income are:
- interest income
- dividend income
- capital gains
When choosing investments for children, choose investments that won’t pay interest or dividends. If you don’t get interest or dividends, you don’t have any interest or dividend income to report.
Next, choose investments that you can hold for decades.
If you buy individual stocks, the company may eventually lose its way. When this happens, you usually sell the stock to avoid watching your investments decrease in value.
Even if a company eventually loses its way, you hopefully have a large gain when you’re ready to sell.
That gain, called a capital gain, is a type of unearned income that can trigger the kiddie tax.
Rather than buying an individual stock that may or may not perform well for decades, you can instead buy a mutual fund or index fund.
If you choose the right mutual fund or index fund, you can have a well diversified investment that you may not need to sell for decades.
Once your child is no longer subject to kiddie tax rules, they can sell these investments if they desire. Alternatively, they can leave the money invested to help fund their future retirement.
2. Use a 529 plan
If you’re giving investments to your kids to help them pay for college, consider using a 529 plan instead.
529 plans won’t give you a tax deduction when you make contributions.
Money taken out to pay for college is income tax-free for federal income tax purposes.
Of course, those looking to set aside money for a future college education should consult a professional, especially if you may qualify for financial aid.
Financial aid formulas are tricky.
Investments held in a minors name and 529 plans can all affect the amount of aid a child receives.
3. Use a Roth IRA
Children aren’t always paying the kiddie tax because their parents gift them investments.
Sometimes, a child that simply wants to invest can run into the kiddie tax on their own.
If a child invests enough money and starts earning enough interest or dividends on those investments, they may be subject to the tax.
They may also be subject to it if they make a great investment and then sell it if the capital gains are high enough.
If this sounds like your situation, you may want to have your child consider what type of account they’re using to invest.
A Roth IRA is an option that might be able to help. It allows a person to contribute earned income to a retirement account.
When you contribute money to a Roth IRA, you do not get a tax deduction.
The best part:
Money withdrawn from a Roth IRA after reaching retirement age is distributed without having to pay tax.
As long as the child has earned income to make the contributions and meets the other requirements, they can invest in this type of account. The account can shelter their interest, dividends and capital gains from taxes.
The child has to wait until retirement age to withdraw the money.
That said, there are certain exceptions that may allow you to withdraw some of the money early without paying taxes and penalties. You must meet strict requirements to do so, though.
Consult a Tax Professional
When it comes to the kiddie tax, you’re best off consulting a tax professional.
This tax is extremely complex. There are also plenty of tax planning opportunities that can help you avoid the kiddie tax.
A tax professional can look at your specific situation and see if you’re at risk of being subject to the kiddie tax. They can also give you actionable advice that could lower your tax liability.