Updated: Jul 5, 2020
The “kiddie tax” is a tax imposed on the unearned income of a child. It was created to prevent parents from shifting their unearned income to their children to lower their tax liability. For “kiddie tax” purposes, a child is considered a minor under age 19. Or, a minor can be age 19-23 if a full time student that meets certain earned income requirements.
Earned versus Unearned Income
Earned income includes all of the taxable income and wages your child gets from working or from certain disability payments. A dependent child whose gross income is only earned income must file a return if the gross income is more than the standard deduction ($12,400 in 2020). Earned income reported on a dependent child's tax return will be taxed at the ordinary income tax rate.
Unearned income can include interest, dividends, and other types of investment income. If your child's unearned income totals more than $2,200, it may be subject to the "Kiddie Tax."
Kiddie Tax Rate
Under the Tax Cuts and Jobs Act (TCJA), the 2018 and 2019 tax rate for the unearned income of dependent children was subject to the tax rate applied to trusts and estates.
This tax rate, however, was changed under the 2020 SECURE Act. Under the SECURE Act, the 2020 tax rates for the unearned income of dependent children reverted back to the marginal tax rate of the child's parents (see tax table). Taxpayers who have not yet filed a 2018 or 2019 return can elect to pay the non-TCJA Kiddie Tax. Alternatively, taxpayers who have filed a 2018 or 2019 return can amend these returns to apply the non-TCJA Kiddie Tax. An analysis of the various Kiddie Tax options is best summed up in the Journal of Accountancy's article "Former Kiddie Tax Rules Restored."
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 ($2,100 for 2018; $2,200 for 2019 and 2020) 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."
Note: A dependent child's investment income might also be subject to the 3.8% Net Investment Tax.
Deductions can be taken against income subject to the kiddie tax. While itemized deductions are an option, most children fall into the standard deduction since they do not accumulate enough expenses to itemize at their young age. The law allows a dependent child to claim the single standard deduction limited to the greater of $1,100 or the sum of the child's earned income plus $350, not to exceed the standard deduction.
Does your child owe the Kiddie Tax?
To determine if your child's income is taxable, the IRS requires all of these conditions be met:
Your child's unearned income was more than $2,200.
Your child meets one of the following age requirements:
a. Under age 18 at the end of the tax year,
b. Age 18 at the end of the tax year and didn't have earned income that was more than half of their support, or
c. 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.
Please keep in mind that not all states have conformed to the new kiddie tax rate. California, for example, will continue to tax a child's investment income at the parent's income tax rate for 2018 and 2019. Discuss the state tax implications with your CPA to make the most informed decision on how to generate income streams for your child.
Income streams for dependent children can be a great means for assisting a child's financial future and building generational wealth. It is important, however, to consider the tax implications. In some cases, it might be more strategic to move a child's investments into a 529 plan that allows income to grow tax free for future qualified education expenses. In other situations, the different earned and unearned income tax rates might make it more cost-effective for a child to earn wages that can be invested within a Roth IRA. 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.