Sep 20
Don’t Forget About the Kiddie Tax!
Digest
The kiddie tax applies the parents’ tax rate to a child’s unearned income above $2,600 (in 2024). To minimise it, families can invest in long‑term growth assets, use 529 plans or Roth IRAs and offset gains with capital‑loss harvesting.
Before 1986, parents could take advantage of a loophole in the tax code to lower their investment income tax liability by transferring investments to their children’s names. This way, the investment income would be taxed at the child’s more favorable ordinary income rate rather than the parents’ higher rates.
To target this issue, the kiddie tax was enacted as part of the Tax Reform Act of 1986 and required a child’s unearned income above a certain threshold to be taxed at the parents’ income tax rates rather than the child’s.
How Does the Kiddie Tax Apply?
The kiddie tax applies to unearned income (interest, dividends, capital gains, inherited retirement accounts, taxable scholarships, etc.) for children under the age of 18 and dependent full-time students under the age of 24 whose investment and unearned income is higher than an annually determined threshold. For 2024, unearned income up to $1,300 is not taxed. The next $1,300 is taxed at the child’s ordinary income tax rate, and any amount above $2,600 is taxed at the parents’ marginal rate.
However, for any child earning less than $11,000 in unearned income (and not otherwise earning earned income), the child’s parent may elect to report the child’s unearned income on the parent’s return (avoiding the need for a filing a separate return for the child) by filing a Form 8814. A child with earned income or more than $12,400 in combined earned and unearned income, however, must file their own return.
How to Reduce or Avoid the Kiddie Tax
Parents seeking to transfer wealth to their children may not understand the tax implications of transferring one type of asset over another. Wherever possible, assets and investments transferred to children should be geared towards long-term growth rather than income production to avoid application of the kiddie tax. For example, clients should invest in mutual funds or index funds that can be held for decades rather than individual stocks that may need to be sold in the short-term.
Additionally, many parents and grandparents open custodial accounts (such as UTMA and UGMA accounts) to save for a child’s future. While these accounts are flexible and have many benefits, adults often fail to recognize the tax consequences if the account grows and produces significant income.
Parents and grandparents may instead consider investing in a tax-advantaged savings plan such as a 529 plan, which can be an excellent way to save for a child’s future college expenses without incurring the kiddie tax. Additionally, a Roth IRA can be a great way to invest for a child that allows after-tax dollars to grow tax-free for decades, and income tax will not have to be paid on funds withdrawn after the child reaches retirement age.
Finally, where possible, tax-loss harvesting strategies can be used to offset a child’s capital gains and reduce his or her tax liability.
Understanding the kiddie tax is essential for families looking to manage their children’s investments and future financial health. By staying informed and planning ahead, you can avoid unexpected tax liabilities and ensure your family’s financial goals stay on track. If you need help navigating the complexities of the kiddie tax or other tax-related matters, give us a call at (512)374-4922 or email hello@hardiealcozer.com to speak with one of our attorneys. We’re here to make sure you and your child are prepared and protected.