Kiddie Tax

The so-called “Kiddie Tax” is a colloquial term used in the United States to describe special tax rules that apply to a minor child’s unearned income. The origin of the Kiddie Tax dates back to the Tax Reform Act of 1986, and its purpose is to prevent parents from shifting income to their children in order to take advantage of the children’s lower tax bracket. Over the years, legislation has evolved, but the primary goal has remained: preventing tax avoidance by shifting unearned income to minors.

Historical Context

Tax Reform Act of 1986

Before the Kiddie Tax was implemented, families could shift income-generating assets to children, who were often in a lower tax bracket. This led to significant tax savings for families with substantial unearned income, such as dividends, interest, and rents. The Tax Reform Act of 1986 introduced the Kiddie Tax to close this loophole. Initially, it applied to children under 14 years old.

Changes Over Time

Later amendments expanded the age range and modified the rules. For example, the Small Business and Work Opportunity Tax Act of 2007 raised the age threshold from 14 to 18 years or to 23 years if the child is a full-time student and does not provide over half of their own support. The Tax Cuts and Jobs Act of 2017 made additional changes, including how the unearned income is taxed, but these changes were subsequently modified by the SECURE Act of 2019.

Understanding Kiddie Tax Rules

Who is Affected?

The Kiddie Tax applies to:

  1. Children under age 18 at the end of the tax year.
  2. Full-time students under age 24 who do not have earned income that exceeds half of their annual support.
  3. Children aged 18 who have unearned income exceeding half of their annual support.

Types of Income

The Kiddie Tax primarily targets unearned income, which includes:

Exclusions

Certain types of income are not subject to the Kiddie Tax rules:

Calculation of Kiddie Tax

The amount of Kiddie Tax a child owes depends on the structure of their unearned income. Here’s how it is generally calculated:

  1. Unearned Income Thresholds: The IRS sets a threshold amount for unearned income. For example, in 2023, the first $1,250 of unearned income is tax-free because of the standard deduction for dependents.
  2. Tax Rate: Unearned income above the threshold is taxed at the parents’ tax rate.
  3. Filing Requirements: A separate tax return must be filed for the child if their income exceeds the standard deduction and any additional allowable deductions.

Example Calculation

Suppose a 16-year-old named Alice has the following unearned income in a tax year:

Total unearned income = $2,000 + $1,000 + $500 = $3,500.

Legislative Updates

Tax Cuts and Jobs Act (TCJA)

The TCJA introduced significant changes to the Kiddie Tax, effective from 2018 through 2025. It modified the way unearned income was taxed, using the same tax brackets applied to estates and trusts instead of the parents’ tax rate. This often resulted in higher taxes because estate and trust tax rates are usually steeper over lower income brackets. For instance:

However, this change was later repealed by the SECURE Act.

SECURE Act

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 reverted the Kiddie Tax calculation to using the parents’ tax rate starting in 2020. Families also had an option to retroactively apply these changes to 2019 and 2018 returns, if it resulted in a lower tax liability.

Planning Strategies

Asset Location

One effective strategy to minimize Kiddie Tax is intelligent asset location. Parents may choose to place high-yield investments in accounts that are not subject to the Kiddie Tax or are tax-advantaged, such as:

Gifting Strategies

Consider gifting assets that generate little to no income or assets that appreciate over time, like growth stocks that are expected to pay low dividends. This defers the recognition of income until the stocks are sold.

Utilizing tax credits for education, such as the American Opportunity Tax Credit or the Lifetime Learning Credit, can alleviate some of the tax pressure associated with unearned income, provided that the child incurs education-related expenses.

Implications for Different Stakeholders

For Families

The Kiddie Tax requires careful financial planning. Families should consider the tax impact on investment choices and gifting strategies, ensuring that the tax burden does not outweigh the benefits of shifting income to a child.

For Financial Advisors

Financial advisors play a crucial role in helping families navigate the intricacies of the Kiddie Tax. They can advise on optimal asset allocation, recommend tax-advantaged accounts, and assist in preparing tax filings to minimize the impact of the Kiddie Tax.

For Policymakers

The evolution of the Kiddie Tax reflects ongoing efforts to balance tax revenue needs with fair tax policy. Policymakers must continue to evaluate the efficacy of the Kiddie Tax in preventing tax avoidance while ensuring it does not place undue hardship on families, particularly those saving for education.

Conclusion

The Kiddie Tax remains a critical component of the U.S. tax code aimed at preventing income shifting to lower tax brackets. While the rules have evolved over time, its primary objective has stayed the same. Proper planning and a deep understanding of the current regulations can help families navigate this complex area to minimize tax liabilities while remaining compliant with the law. For financial advisors and tax professionals, staying informed about the latest changes ensures they can provide the best possible advice to their clients.