If your child is the beneficiary of a UGMA/UTMA account, an inherited IRA or other investment account, their income could be subject to the kiddie tax.
This tax was created to prevent parents from shifting their unearned income to their children to lower their tax liability.
Not sure if the kiddie tax applies to you?
Check out these 8 facts that breakdown the nuances of this tax.
1. Who is a kiddie?
Per the IRS, a kiddie is a dependent child under age 19. Or, a kiddie can be age 19-23 if they are a full time student that meets certain earned income requirements.
2. Earned versus Unearned Income
Shoveling snow, acting in a TV commercial, and possibly winning Fortnite V-Bucks (check with your tax advisor on that one) are all examples of earned income.
Earned income includes all of the taxable income your child receives from working. It also includes certain disability payments.
A dependent child who only has earned income must file a tax return if their gross income is more than the standard deduction ($12,550 in 2021).
Earned income reported on a dependent child’s tax return will be taxed at the ordinary income tax rate.
Unearned income, on the other hand, is subject to a different rate.
Interest, dividends, and other types of investment income are examples of unearned income
If your child’s unearned income totals more than $2,200, it may be subject to the “Kiddie Tax” rate.
3. Kiddie Tax Rate
According to the 2019 SECURE Act, the kiddie tax rate for a dependent child’s unearned income should equal the highest marginal tax rate of the child’s parents.
[Your marginal tax rate is the amount of tax incurred for each additional dollar of income].
4. How to Calculate the Kiddie Tax
A recent MarketWatch article explains how to calculate the 2020 Kiddie Tax –
“First, add up the child’s net earned income and net unearned income. Then subtract the child’s standard deduction to arrive at taxable income. The portion of taxable income that consists of net earned income is taxed at the regular rates for a single taxpayer. The portion of taxable income that consists of net unearned income and that exceeds the unearned income threshold ($2,200 for 2021) is subject to the Kiddie Tax and is taxed at the parent(s)’ marginal federal income tax rate. That rate can be as high as 37% for ordinary income and short-term gains and 20% for long-term gains and dividends.” – Bill Bischoff, Tax Columnist, MarketWatch
Note: A dependent child’s investment income might also be subject to the 3.8% Net Investment Tax.
5. Deductions
Deductions can be taken against income subject to the kiddie tax.
Although itemized deductions can reduce taxable unearned income, most children will use the standard deduction since they do not accumulate enough expenses to itemize at their young age.
For unearned income, the law allows a dependent child to claim the single standard deduction limited to $1,100, with the next $1,100 being taxable.
If the sum of the child’s earned income plus $350 is greater than $1,100, this sum can replace the $1,100 standard deduction.
Keep in mind, this sum cannot exceed the earned income standard deduction ($12,550 for single filers in 2021).
6. How do you report unearned income subject to the kiddie tax?
To report unearned income subject to the Kiddie Tax, the IRS requires you to attach Form 8615 to your child’s tax return if all of these conditions are met:
- Your child’s unearned income was more than $2,200.
- Your child meets one of the following age requirements:
- Under age 18 at the end of the tax year,
- Age 18 at the end of the tax year and didn’t have earned income that was more than half of their support, or
- Full-time student at least age 19 and under age 24 at the end of the tax year and didn’t have earned income that was more than half of their support.
- At least one of your child’s parents was alive at the end of the tax year.
- Your child is required to file a tax return for the tax year.
- Your child will not file a joint return for the tax year.
If your child’s only income is interest and dividend income (including capital gain distributions) and totals less than $11,000, you may be able to elect to include that income on your return rather than file a return for your child.
For more information see IRS Topic No. 533.
7. State Tax
Please keep in mind that not all states conform to the IRS’ kiddie tax rules.
Discuss the state tax implications with your CPA to make the most informed decision on how to generate income streams for your child.
8. Tax Planning
Providing passive income for your children is a great way to build generational wealth.
It is important, however, to consider the tax implications to plan properly and make the most informed decisions.
Whatever income options are available to your child, it is always a good idea to consult with a CPA to work through which tax strategy is best for your family’s financial future.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers before engaging in any transaction.