#kiddietax

First, a little background on the kiddie tax. Previously, a widely-used tax-saving strategy for high-income families was to funnel unearned income through their children to reduce their overall taxes (unearned income refers to investments, such as interest, dividends and capital gains). Since the child’s tax rate in almost every case was much lower than the parents, the parents could earn money while paying very little tax. As you can imagine the IRS was not a huge fan of this and in 1986 Congress stepped in and enacted the kiddie tax. The purpose was to limit this funneling strategy by taxing certain amounts of children's unearned income at a very high rate. Later on the kiddie tax was expanded so that it's now applicable to the unearned income of much older children (it used to apply to children under 14 but now it applies to children under 19 or even older, if your child is in school).

Under the kiddie tax, children pay tax at their own income tax rate on unearned income they receive up to a threshold amount ($2,100 in 2015). However, all unearned income they receive above the threshold amount is taxed at their parent's income tax rate. As a result, the children’s income could be taxed as high as 35%, compared to the 10% rate that most children would be paying. Any unearned income below the standard deduction amount ($1,050 in 2015) is not taxed or reported to the IRS at all.

The resulting effect is that you get the benefit of the child's lower tax rate only for unearned income over the standard deduction amount ($1,050) and below the threshold amount ($2,100). Everything else above the threshold amount is taxed at the parent's rate.

It should be noted that the kiddie tax applies only to unearned income a child receives from income-producing property, such as cash, stocks, bonds, mutual funds, and real estate. Any salary or wages that a child earns through full or part-time employment are not subject to the kiddie tax rules; rather that income is taxed at the child's tax rate.

So now that I know what the kiddie tax is, how can I actually benefit from these rules? First, you should realize that although a $2,100 threshold does not sound like a lot, it’s actually a fair amount of unearned income for a child. For example, a child whose investments earn 5% per year would have to have over $42,000 in cash or property investments to earn at least $2,100. Now just for the sake of comparison, I just checked my daughter’s piggy bank and she had only $8.23. So I think she will be safe from the kiddie tax for the near future. As you can see, this tax really tends to be relevant to high-income taxpayers.

In cases where the kiddie tax doesn't apply to your children (they do not have a sizable amount of unearned income), you can give them all the money or property you want and their unearned income will be taxed at their rate so long as it’s below the $2,100 threshold. Even better, if this results in producing less than $1,050 in unearned income then it’s not even taxed at all. So this shift in property can be a huge tax savings. (On second thought, maybe it can actually be cute and cuddly after all.)

But how can someone benefit even in cases where their children are already subject to the kiddie tax? If you give your child investments that appreciate in value over time but don't generate much income until they're sold (which can be at age 24 when the child pays tax at their own rate and the kiddie tax is no longer applicable) then there is no need to be concerned with the kiddie tax. Examples of these investments include Treasury bills, US savings bonds, municipal bonds, and tax-managed mutual funds.