The Tax Code imposes a "kiddie tax" on the unearned income of children who are under 19 (under 24 if a student). When a qualified child has unearned income in excess of a certain amount, the kiddie tax may be applied to that income at the parents' tax rate instead of the child's tax rate. That amount is $2,100 for 2015 as adjusted for inflation. Unearned income can include interest, dividends, capital gains, and royalties.
Congress created the kiddie tax to prevent abuses. It is designed to lessen the effectiveness of intra-family transfers of income-producing property, which shift income produced from such property from the parents' high marginal tax rate to the child's generally lower tax bracket, thereby reducing a family's overall income tax liability.
The kiddie tax applies when at least one of the child's parents is alive at the close of the tax year, the child is not married, and the child falls into one of three categories. The categories are:
- The child has not attained the age of 18 by the close of the tax year
- The child has not attained the age of 19 by the close of the tax year, and the child's earned income is less than one-half of the child's support for the year
- The child is a student who has not attained the age of 24 by the close of the tax year, and the child's earned income is less than one-half of the child's support for the year.
Generally, the parent whose taxable income is taken into account is the custodial parent, if the parents are divorced or otherwise not remarried. If the parents are married, but are filing separate returns, the return of the parent with the greater taxable income must be used.
The age cap on the kiddie tax allows you to plan in several ways. You may want to set up a gift-giving program. You may also want to wait to transfer property that will produce the most income only starting after the year in which the child reaches 19 (or 24 if he or she continues in school). An investment in raw land with appreciation potential is one example. Some parents buy Series EE bonds for the child and have the child elect to defer tax on the interest as it accrues.
Do not forget that the kiddie tax applies only to unearned income. If you own your own business, you may get savings if your child can legitimately be hired to work in the business - see article in this newsletter.
Of course, careful planning and attention to detail are necessary, not only to achieve the intended tax consequences, but also to ensure that any action fits in with your overall financial and family goals. Please do not hesitate to call if you would like to explore in greater detail the kiddie tax rules and any of these or other tax-saving ideas.