Understanding the Kiddie Tax
The Kiddie Tax, a set of tax rules introduced in 1986, aims to prevent high-income parents from shifting their investment income to their children, who typically fall into lower tax brackets. This tax applies to unearned income, such as dividends, interest, and capital gains, of certain children under the age of 19, or under 24 if they are full-time students who aren’t self-supporting.
Exemptions and Thresholds
The Kiddie Tax rules don’t apply to children who are married or if neither parent is alive on the last day of the year. For 2023, the first $1,250 of a child’s unearned income is tax-free. The next $1,250 is taxed at the child’s rate, which is typically lower than the parents’ rate. However, any unearned income over $2,500 is taxed at the higher of the child’s tax rate or the parents’ rate, which can be as high as 37%. These amounts are inflation-adjusted and for 2024 will be $1,300 and $2,600.
Earned Income and Tax Implications
A child’s earned income (income from working, generally W-2 income) is taxed at their marginal rate. However, thanks to the standard deduction, which can offset earned income, and for 2023 for a single individual is $13,850, a child can earn $13,850 tax-free. Inflation-adjustment is expected to bring the 2024 standard deduction to $14,600.
Creative Strategies to Minimize Kiddie Tax Impact
- Earned Income Strategy: The child may also make deductible contributions to a traditional IRA for 2023 of the lesser of their earned income or $6,500. Combining the standard deduction and the maximum deductible IRA contribution, a child could earn $20,350 ($13,850 + $6,500) of wages and pay no income tax.
- Parent or Grandparent Contribution: If the child balks at contributing their hard-earned money to an IRA, the parent, or grandparents, might consider giving the child part or all of the IRA contribution as a gift.
- Roth IRA for Long-Term Benefits: For long-term retirement benefits, it might be better to have the child contribute to a Roth IRA. Even though contributions to a Roth IRA are not tax-deductible, all earnings are tax-free at retirement.
- Parent’s Return Election: In some cases, parents may elect to include their child’s interest and dividend income on their own tax return instead of the child filing a return of their own.
- Kiddie Tax Avoidance Strategies:
- U.S. Savings Bonds: Interest can be deferred until the bonds are cashed.
- Tax-Deferred Annuities: Interest can be deferred until the annuity is surrendered.
- Municipal Bonds: Generally produce tax-free interest income (may be taxable to the state).
- Growth Stocks: Stocks that focus more on capital appreciation than current income.
- Unimproved Real Estate: That provides appreciation without current income.
Seek Professional Guidance
Every family’s financial situation is unique, and what works for one may not work for another. If you have questions about the Kiddie Tax or need assistance with tax planning, don’t hesitate to give this office a call. We can provide personalized advice tailored to your specific circumstances.