How to Avoid the Kiddie Tax: A Guide for Savvy Families

The kiddie tax can be a rude awakening for parents who aren’t prepared. It’s a set of rules designed to prevent parents from sheltering income by transferring assets to their children. But don’t fret, navigating these waters is possible. The best way to avoid the kiddie tax is multifaceted: prioritize earned income for your child (from jobs or self-employment), limit unearned income to below the threshold where the tax kicks in (currently around $2,600), structure investments strategically, and consider using tax-advantaged accounts like 529 plans for education savings. Understanding the rules and employing proactive strategies are key to minimizing the impact of the kiddie tax.

Understanding the Kiddie Tax

The kiddie tax isn’t some newfangled invention. It’s been around for a while, tweaked and modified over the years. Originally, it was designed to target high-income parents who were gifting assets to their children in lower tax brackets to reduce their overall tax burden. Today, it applies to unearned income (like dividends, interest, capital gains, rents, royalties, and trust distributions) above a certain threshold for children who meet specific age and dependency requirements.

Who Does the Kiddie Tax Affect?

The kiddie tax applies to children who meet all of the following criteria:

• Are under age 18.
• Are age 18 and their earned income doesn’t exceed half of their support.
• Are age 19 through 23 and are full-time students, and their earned income doesn’t exceed half of their support.

It’s important to note the dependency requirement: the child must be claimed as a dependent on someone else’s return (typically a parent’s) for the kiddie tax rules to apply.

Unearned Income Thresholds

Understanding the threshold for unearned income is vital for tax planning. As of 2024, the rules generally work as follows:

• The first $1,300 of unearned income is tax-free.
• The next $1,300 of unearned income is taxed at the child’s tax rate.
• Unearned income above $2,600 is taxed at the parent’s tax rate (or the rate that would apply if the parent’s income were included on the child’s return), regardless of the child’s actual income bracket.

This last point is critical. If a child has, say, $10,000 of unearned income, the amount above $2,600 (which is $7,400) will be taxed at the parent’s rate, which could be significantly higher than the child’s.

Strategies to Navigate the Kiddie Tax

So, how do you steer clear of the kiddie tax’s sting? Here are several strategies to consider:

1. Prioritize Earned Income: This is perhaps the most straightforward approach. Encourage your child to earn income through part-time jobs, summer employment, or even self-employment. Earned income is taxed at the child’s rate, which is often much lower than the parent’s. Plus, it instills a valuable work ethic!

2. Control Unearned Income: Be mindful of how much unearned income your child receives. If possible, limit it to below the $2,600 threshold. This might involve adjusting investments, delaying distributions, or exploring alternative savings vehicles.

3. Tax-Advantaged Accounts: Utilize tax-advantaged accounts like 529 plans or Coverdell ESAs for education savings. While contributions aren’t typically deductible, earnings grow tax-free, and withdrawals are tax-free when used for qualified education expenses. This can significantly reduce the potential impact of the kiddie tax.

4. Series EE or I Bonds: Consider purchasing Series EE or I savings bonds in your child’s name. While the interest is technically unearned income, it’s not taxable until the bonds are redeemed. You can time the redemption for when the child is older and potentially out of the reach of the kiddie tax. Alternatively, if the interest each year is kept below the kiddie tax thresholds, the impact can be minimized.

5. Delay Gifting Assets: If possible, delay gifting significant assets until your child is older than 23 or no longer a full-time student. This allows them to manage the assets and any resulting income at their own tax rate, bypassing the kiddie tax altogether.

6. Consider Custodial Roth IRAs (for Earned Income): If your child has earned income, consider opening a Custodial Roth IRA. Contributions are made with after-tax dollars, but earnings grow tax-free, and withdrawals in retirement are also tax-free. While the contributions don’t directly reduce kiddie tax liability, it’s a powerful long-term savings tool.

7. Gift Appreciated Assets to Charity: While not directly impacting the kiddie tax, gifting appreciated assets to a charity can reduce your taxable income, freeing up funds to support your child in other ways. Consult with a financial advisor to determine if this strategy is right for your situation.

8. Strategic Investment Allocation: Review the asset allocation of your child’s investments. Consider shifting towards investments that generate less current income, such as growth stocks instead of high-dividend stocks. This can help keep unearned income below the threshold.

9. Consider Trusts Carefully: While trusts can be useful estate planning tools, they can also trigger the kiddie tax, depending on how they are structured. Be sure to consult with an estate planning attorney to understand the tax implications of any trust established for your child.

10. Understand the Support Test: Remember, the kiddie tax only applies if the child is claimed as a dependent. If the child provides more than half of their own financial support, they may not be subject to the kiddie tax rules, even if they are under 24 (if a student). Keep meticulous records of your child’s income and expenses to determine who provides the majority of support.

Frequently Asked Questions (FAQs)

1. If my child is 17 and has $3,000 of unearned income, how much will be taxed at my rate?

   • $3,000 (total unearned income) – $1,300 (tax-free amount) – $1,300 (taxed at the child’s rate) = $400. $400 will be taxed at your (the parent’s) tax rate.

2. My child is 20, a full-time student, and I provide more than half of their support. They have $5,000 in a brokerage account. Does the kiddie tax apply?

   • Yes, the kiddie tax applies because your child is between 19 and 23, a full-time student, and you provide more than half of their support. The unearned income above $2,600 (in this case, $2,400) will be taxed at your rate.

3. What if my child’s unearned income is solely from a savings account?

   • The interest earned from a savings account is considered unearned income and is subject to the kiddie tax if it exceeds the threshold ($2,600 in 2024).

4. Does the kiddie tax apply to inherited IRAs?

   • Distributions from inherited IRAs are generally treated as unearned income. If the child is subject to the kiddie tax, the distributions above the threshold will be taxed at the parent’s rate. Consult with a tax professional for specific guidance.

5. Are there any exceptions to the kiddie tax rules?

   • Yes, the kiddie tax doesn’t apply if both parents are deceased. In this case, the child’s unearned income is taxed at the child’s own tax rate.

6. Can I claim my child as a dependent if the kiddie tax doesn’t apply?

   • Yes, the dependency rules are separate from the kiddie tax rules. You can still claim your child as a dependent if they meet the dependency requirements, even if their income is taxed at their own rate.

7. How do I report the kiddie tax on my child’s tax return?

   • You’ll need to use Form 8615, Tax for Certain Children Who Have Unearned Income. This form calculates the amount of tax owed under the kiddie tax rules and is filed with your child’s individual income tax return (Form 1040).

8. Can I deduct my child’s expenses against their unearned income?

   • Yes, certain expenses related to generating the unearned income can be deducted. For example, investment expenses can be deductible, subject to limitations.

9. If my child has both earned and unearned income, which is taxed first?

   • Earned income is taxed at the child’s tax rate, while unearned income is taxed according to the kiddie tax rules (first $1,300 tax-free, next $1,300 at child’s rate, and the rest at the parent’s rate).

10. What happens if my child’s unearned income exceeds my own taxable income?

    • The kiddie tax rules still apply. The unearned income above $2,600 will be taxed at the parent’s marginal tax rate, even if that exceeds the parent’s total taxable income.

11. Is it possible to amend a tax return if I didn’t properly report the kiddie tax?

    • Yes, you can amend your child’s tax return using Form 1040-X, Amended U.S. Individual Income Tax Return. It’s important to correct any errors as soon as possible to avoid penalties and interest.

12. Should I consult a tax professional about the kiddie tax?

    • Absolutely. The kiddie tax can be complex, and the rules can change. A qualified tax professional can help you understand how the kiddie tax applies to your specific situation and develop a plan to minimize its impact. They can also provide guidance on investment strategies, tax-advantaged accounts, and other tax planning strategies.

Navigating the kiddie tax requires careful planning and a thorough understanding of the rules. By prioritizing earned income, strategically managing unearned income, and utilizing tax-advantaged accounts, you can help your children build a secure financial future without unnecessary tax burdens. Remember, proactive planning and seeking professional advice are your best defenses against the kiddie tax.