Dictionary
What is Kiddie Tax?
Kiddie Tax refers to a special tax rule applied to the unearned income of certain children, typically under the age of 18 or full-time students under the age of 24. The Internal Revenue Service (IRS) introduced this tax in 1986 to prevent parents from shifting their investment income to their children, who usually have a lower tax rate. Essentially, this tax rule aims to discourage parents from attempting to reduce their overall tax burden by taking advantage of their children's lower taxed earnings.
Why the Need for Kiddie Tax?
Before the Kiddie Tax's introduction, parents and guardians often transferred high-yielding assets, such as bonds, stocks, or mutual funds, to their children's names to circumvent higher tax rates. Since children typically fell in the lower tax brackets, their unearned income would be subject to a significantly lower tax rate compared to that of their parents.
For instance, consider a high-income family with an annual income of $200,000. By transferring investment assets to their child, who has a lower income, the family could save significantly on taxes. The introduction of the Kiddie Tax curtailed this practice, ensuring a more equitable distribution of tax liability.
How Does Kiddie Tax Work?
Under the Kiddie Tax rule, the unearned income of a child is subject to specific tax rates. Unearned income refers to the income generated from investments, such as interest, dividends, and capital gains. The parent's tax rate determines the portion of the child's investment income that is subject to the Kiddie Tax.
To understand the Kiddie Tax application, it is essential to break down the income categories:
Earned income: It refers to income earned through employment or self-employment, such as wages, tips, or commissions. Earned income is subject to the child's tax rate and is not affected by the Kiddie Tax.
Unearned income: It is income derived from sources other than employment or wages, such as rental income, dividends, interest, and capital gains. The Kiddie Tax affects this income category.
To illustrate the Kiddie Tax application, let's discuss an example. Imagine a 17-year-old with a part-time job and investment income. The child earns $5,000 annually from their job and also receives $2,500 in dividends from their investments. Since the child earned $5,000 through their job, the earned income is subject to the child's tax rate. On the other hand, the $2,500 in dividends, considered unearned income, is subject to Kiddie Tax.
Taxable Threshold for the Kiddie Tax
The IRS sets an annual threshold for the Kiddie Tax, which can change yearly. In 2021, the first $1,100 of a child's unearned income is tax-exempt, and the next $1,100 is taxed at the child's rate. If the unearned income exceeds $2,200, the excess amount is subject to the Kiddie Tax and is taxed at the parent's tax rate.
Who is Subject to the Kiddie Tax?
The Kiddie Tax applies to children who:
- Are under the age of 18, or
- Are 18 years old but didn't have earned income exceeding half of their annual support, or
- Are aged 19-23, full-time students, and don't have their own earned income that is more than half of their annual support.
Exceptions exist for certain cases, such as when the child is married or when both parents are deceased.
How to Report Kiddie Tax
Parents can choose to report the Kiddie Tax on their own tax return using IRS Form 8814, or the child can file their tax return separately. It is crucial to note that including the child's income on the parents' tax return may increase their overall tax liability. Therefore, it is essential for parents to compare the potential tax implications and make an informed decision.
Recent Changes to Kiddie Tax
The 2017 Tax Cuts and Jobs Act (TCJA) briefly changed the Kiddie Tax calculation, taxing the child's unearned income using tax rates applicable to trusts and estates. However, this alteration led to complexities and, in some cases, a higher tax rate. In December 2019, the Further Consolidated Appropriations Act repealed the TCJA changes, reinstating the previous Kiddie Tax calculation.
Conclusion
The Kiddie Tax is an essential tool designed to prevent high-income families from exploiting tax loopholes to minimize their liabilities. Understanding the Kiddie Tax and its implications can help families make informed financial decisions and prevent potential tax complications.