What Is the Kiddie Tax?

What Is the Kiddie Tax?

Let me explain the kiddie tax to you directly. It was introduced with the Tax Reform Act of 1986, and its main goal is to target unearned income of minors and young adults. This prevents families from evading taxes by shifting investment income to their children.

This tax kicks in for unearned income above a certain limit if you're a child under 18 or a dependent full-time student under 24. Anything below that limit gets taxed at your own rate as the child, but above it, it's taxed at your guardian's rate, which could go up to 37%. The threshold adjusts yearly for inflation, so keep an eye on that.

Key Takeaways

Here's what you need to know upfront. The kiddie tax applies to unearned income for anyone 18 or younger, and full-time students up to 24, making sure parents don't exploit loopholes by moving investments to their kids.

Unearned income below the limit is taxed at the child's rate, but anything over is hit with the parent's potentially higher rate, up to 37%. It includes things like dividends, interest, and capital gains, but not income from a job.

This tax started in 1986 to stop parents from using kids' lower rates, and a 2020 law brought back the parent's rate after a brief change in 2017. You can avoid it with smart investments that keep unearned income under the threshold.

Understanding the Mechanics of the Kiddie Tax

The kiddie tax focuses on individuals under a certain age with investment and unearned income over a yearly threshold. It covers all children 18 and under at year's end, plus dependent full-time students from 19 to 24.

Important note: It doesn't apply to kids under 24 who are married and file joint returns. The rule stops parents from gifting stocks to kids, letting them realize gains at lower rates than the parents would face.

It includes unearned income like interest, dividends, capital gains, rent, and royalties, but skips salary or wages from work. Tip for you: Adult children turning 19—or 25 for dependent students—by year-end escape the kiddie tax.

What Is the Kiddie Tax Rate?

Under this law, unearned income over the threshold gets taxed at the guardian's marginal rate, not the child's. The first chunk qualifies for a standard deduction, then the next is at the child's low rate—sometimes 0%—and anything above is at the guardian's rate, up to 37%.

Warning: The IRS applies the parent's rate to income exceeding the threshold, so plan accordingly.

Reporting Kiddie Tax: What You Need to Know

You have two main ways to report a child's unearned income. First, parents can include the child's interest, dividends, and capital gains on their own return using Form 8814.

Second, the child reports it on Form 8615 attached to their Form 1040. Use the first option if the income is just interest and dividends under $11,000; otherwise, go with the second, likely with parental help.

The Evolution of the Kiddie Tax: A Historical Overview

Originally, it applied only to kids under 14, who got income from dividends or interest since they couldn't work legally. But authorities saw guardians gifting stocks to older teens 16 to 18 to exploit the system.

The 2017 Tax Cuts and Jobs Act temporarily switched to estate and trust rates instead of parents'. Then the 2020 Further Consolidated Appropriations Act reverted it back to the parent's rate, retroactively. For 2018-2019, you could choose either; from 2020 on, it's the parent's rate.

Who Is Subject to Kiddie Tax?

It's imposed on those under 18 or dependent full-time students under 24 with unearned income above the annual threshold.

What Is the Purpose of the Kiddie Tax?

Created in 1986, it stops parents from putting investments in kids' names to pay less tax. Investment income is taxed at ordinary rates based on earnings.

How Do I Avoid Kiddie Tax?

You can avoid it by keeping the child's annual investment income below the threshold. Do this with low-income assets, or bonds where interest defers until the child ages out.

The Bottom Line

The kiddie tax hits unearned income over a threshold for young people, closing an old loophole—something parents must watch. If you're investing for a child, talk to a financial or tax advisor. Know the rules and your duties, and remember there are ways to minimize or avoid this tax.