Kiddie Tax

Kiddie Tax: Rules, Rates, and Strategies to Reduce Tax Liability

The kiddie tax is a tax regulation that applies to unearned income received by children, ensuring that families do not shift investments to their children to benefit from lower tax rates. Introduced to prevent tax avoidance, it affects dependent children under a certain age, particularly those with significant investment earnings.

Children who receive substantial unearned income from sources such as dividends, interest, and capital gains face taxation at their parents’ marginal tax rate instead of their lower tax bracket. This regulation prevents parents from transferring investment assets into their child’s name solely to reduce the tax burden. The rules governing the kiddie tax have evolved over time, adjusting thresholds and tax rates to align with broader tax policies.

It is essential for parents and guardians to understand how the kiddie tax works, who it affects, and the strategies available to mitigate its impact. Managing investments tax-efficiently can help reduce unexpected tax liabilities while ensuring compliance with tax regulations.

History of the Kiddie Tax

The kiddie tax was first introduced in the Tax Reform Act of 1986 as a response to tax avoidance strategies where parents transferred investment assets to their children to take advantage of their lower tax brackets. Before its introduction, families could shift significant amounts of unearned income to their children and enjoy lower taxation.

Initially, the tax applied only to children under 14, but subsequent amendments extended its reach. The Small Business and Work Opportunity Tax Act of 2007 raised the age limit to 18 years and included full-time students under 24 whose earned income did not exceed half of their total financial support.

Further changes occurred with the Tax Cuts and Jobs Act (TCJA) of 2017, which altered how the tax was calculated. The law imposed trust tax rates instead of parental tax rates, often resulting in higher tax liabilities for affected families. However, the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 reversed these changes, restoring the original system where the child’s unearned income is taxed at the parent’s marginal rate.

Over time, adjustments have been made to reflect inflation, but the core principle remains unchanged. The kiddie tax prevents tax avoidance by ensuring children’s investment income is taxed appropriately rather than benefiting from artificially low tax brackets.

Who is Subject to the Kiddie Tax?

The kiddie tax applies to dependent children who meet specific criteria based on age, income type, and financial dependency. Children subject to this tax are classified under the following conditions:

• They are under 18 years old at the end of the tax year.
• They are 18, but their earned income does not exceed half of their total financial support.
• They are full-time students under 24 years old, with unearned income exceeding the threshold, and do not provide at least half of their financial support.

The tax applies only to unearned income, which includes investment returns and other passive income sources. Children who earn wages, salaries, or self-employment income are not subject to this tax, as earned income is taxed under regular income tax rates.

Not all children are affected by the kiddie tax. If a child is financially independent and provides more than half of their total support through earned income, they are exempt from this tax. Additionally, children who file as independent taxpayers and are not claimed as dependents do not fall under the kiddie tax rules.

Types of Income Subject to Kiddie Tax

The kiddie tax specifically targets unearned income, ensuring that passive income sources are not used as a loophole for tax minimisation. Unearned income includes:

Interest Income

Interest income refers to the earnings generated from bank savings accounts, bonds, certificates of deposit (CDs), and other fixed-income investments. This type of income is typically earned passively, as financial institutions or bond issuers pay interest periodically.

For children with significant savings in interest-bearing accounts, the accumulated interest can quickly exceed the kiddie tax threshold. Interest from U.S. Treasury, corporate, and municipal bonds is also considered unearned income.

• Bank savings account interest: This is the most common type of interest income and is taxable in the year it is earned, even if the funds remain in the account.
• Certificates of deposit (CDs): Interest is earned at a fixed rate, and depending on the CD terms, taxes may be due annually or when the CD matures.
• Bond interest: Treasury bonds, corporate bonds, and savings bonds generate periodic interest payments, which are taxable in the year they are received.
• Municipal bond interest: While typically exempt from federal taxes, municipal bond interest may still be subject to state and local taxes.

If a child’s total interest income exceeds the kiddie tax threshold, the excess amount will be taxed at the parents’ marginal tax rate instead of the child’s lower tax rate. Parents can consider tax-exempt bonds or investing in low-yield accounts to reduce tax exposure.

Dividends

Dividends are payments made by corporations, mutual funds, and exchange-traded funds (ETFs) to shareholders as a portion of company profits. They represent a significant source of passive income for investors and are classified into two types for tax purposes:

• Qualified dividends: These receive preferential tax treatment and are taxed at the lower long-term capital gains rate, provided they meet the required holding period.
• Ordinary (non-qualified) dividends: These are taxed as ordinary income, following standard income tax brackets.

Dividends earned by children from stocks or mutual funds are considered unearned income and may be subject to the kiddie tax. If the total dividend earnings exceed the kiddie tax threshold, the excess is taxed at the parents’ marginal rate.

Parents should consider holding growth stocks instead of dividend-paying stocks if they want to defer taxation. Growth stocks reinvest earnings into the company rather than paying out dividends, allowing investors to delay capital gains tax until the stock is sold.

Capital Gains

Capital gains are profits from selling investments such as stocks, bonds, mutual funds, exchange-traded funds (ETFs), or real estate. They are categorized based on the duration the asset was held before selling:

• Short-term capital gains (held for less than one year) are taxed as ordinary income at the child’s tax rate.
• Long-term capital gains (held for more than one year) are taxed at the lower capital gains tax rate.

Under the kiddie tax, long-term capital gains above the threshold will be taxed at the parent’s tax rate instead of the child’s lower capital gains rate. Children with investment portfolios that include actively traded stocks or mutual funds may trigger capital gains more frequently, increasing their tax liability.

Parents can use strategies to minimize taxable capital gains:

• Holding investments for the long term to benefit from preferential tax rates.
• Tax-loss harvesting, which involves selling underperforming investments to offset gains.
• Investing in tax-efficient funds that limit annual capital gains distributions.

For real estate investments, profits from selling property held in a child’s name will also be taxed under the kiddie tax rules if the capital gains exceed the unearned income threshold.

Custodial Account Earnings

Custodial accounts under the Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) allow parents or guardians to transfer financial assets to a child. These accounts remain under parental control until the child reaches the age of majority, but the earnings generated are considered the child’s income for tax purposes.

Unearned income from custodial accounts includes:

• Interest from savings or bonds held in the account.
• Dividends from stocks, mutual funds, or ETFs.
• Capital gains from the sale of investments within the custodial account.

If the unearned income from a custodial account exceeds the kiddie tax limit, the excess amount will be taxed at the parents’ marginal tax rate. Since custodial accounts do not offer tax-deferred growth, parents may consider transferring assets into a 529 college savings plan to reduce tax liability.

Once the child reaches the legal age of majority (18 or 21, depending on the state), they gain full control over the custodial account. At that point, any investment income will be taxed based on standard tax brackets rather than under kiddie tax regulations.

Trust Distributions

A trust is a legal arrangement where assets are managed by a trustee on behalf of beneficiaries. If a child is named a trust beneficiary, any income distributions they receive from the trust may be subject to the kiddie tax. The tax treatment depends on the type of trust:

• Revocable (grantor) trusts: These remain under the grantor’s control (parent or guardian), and any income generated is reported on the grantor’s tax return rather than the child’s return.
• Irrevocable trusts: Once assets are placed in an irrevocable trust, they separate from the grantor’s estate. Income distributed to the child is considered unearned and may be taxed under the kiddie tax rules.
• Discretionary trusts: Trustees have flexibility in determining distributions. Income accumulated within the trust is taxed at trust tax rates rather than the child’s or parent’s tax rates.

If trust distributions exceed the kiddie tax threshold, they will be taxed at the parents’ marginal tax rate instead of the child’s lower tax bracket. Families using trusts for estate planning should consider structuring distributions to minimize tax liability while ensuring financial benefits for the child.

Rental Income

Rental income is another form of unearned income that is subject to the kiddie tax. If a property is held in a child’s name and generates rental income, that income must be reported on their tax return and may be subject to taxation under kiddie tax rules.

Rental income includes:

• Monthly rent payments from tenants.
• Security deposit earnings if retained as income.
• Short-term rental income from platforms like Airbnb or Vrbo.

Additionally, rental income is subject to deductions for expenses such as property maintenance, mortgage interest, insurance, and property taxes. However, even after deductions, net rental income exceeding the kiddie tax threshold will be taxed at the parents’ tax rate.

Parents considering property investments in their child’s name should know the potential kiddie tax implications. Instead of direct ownership under a child’s name, families may explore alternative ownership structures, such as family or real estate investment trusts (REITs), to manage tax liabilities more efficiently.

Points to Remember

• Earned income, such as wages from employment, self-employment earnings, or freelance work, is not subject to the kiddie tax. It is taxed based on standard income tax brackets applicable to individuals.
• The distinction between unearned and earned income is crucial, as earned income allows a child to claim a standard deduction and is subject to lower tax rates. In contrast, unearned income that exceeds a set threshold is taxed at the parents’ marginal rate.

Kiddie Tax Thresholds and Tax Rates for 2024 and 2025

Each year, the IRS sets income thresholds that determine how much unearned income a child can receive before being subject to the kiddie tax. The thresholds for 2024 and 2025 are structured as follows:

2024 Thresholds

• First $1,300 – Tax-free (covered by the standard deduction).
• Next $1,300 – Taxed at the child’s rate.
• Unearned income above $2,600 – Taxed at the parents’ marginal tax rate.

2025 Thresholds

• First $1,350 – Tax-free.
• Next $1,350 – Taxed at the child’s rate.
• Unearned income above $2,700 – Taxed at the parents’ tax rate.

These rates ensure that small investment earnings remain minimally taxed, while higher unearned income is taxed in line with the parents’ taxable income. For families with significant investment assets under a child’s name, it is essential to stay updated on annual threshold changes. Careful tax planning can help prevent unexpected tax liabilities, especially for children with growing investment portfolios.

How to Report Kiddie Tax on a Tax Return?

Filing requirements for the kiddie tax depend on how much-unearned income the child receives during the tax year. If the child’s investment income exceeds the specified threshold, parents must file additional tax forms:

• IRS Form 8615 – Used when a child files their tax return but has unearned income exceeding the threshold.
• IRS Form 8814 – Allows parents to report the child’s investment income on their tax return, simplifying the process in cases where total unearned income does not exceed $12,500.

When a child’s unearned income is low, filing separately may result in lower overall taxes. However, for children with significant investment earnings, filing with the parents’ return may streamline tax obligations and ensure compliance with reporting requirements.

How Does Kiddie Tax Affect Different Investment Types?

Different types of investments can generate unearned income that falls under the scope of the kiddie tax. The taxation of these investments varies depending on how they are structured and whether they offer tax advantages. Understanding how different assets impact tax liability can help in financial planning.

529 Plan Earnings

A 529 plan is a tax-advantaged savings account designed for education expenses. Earnings within the plan grow tax-free, and qualified withdrawals are not subject to the kiddie tax. However, if funds are withdrawn for non-educational purposes, the earnings portion of the withdrawal becomes taxable and may be subject to an additional 10% penalty.

Parents looking to save for their child’s education while avoiding kiddie tax implications should consider contributing to a 529 plan instead of a custodial account.

Capital Gains and Kiddie Tax

Capital gains occur when an asset, such as a stock or mutual fund, is sold for a profit. The taxation of capital gains depends on how long the asset was held before the sale:

• Short-term capital gains (held for less than one year) are taxed as ordinary income.
• Long-term capital gains (held for more than one year) are taxed at preferential capital gains rates.

Under the kiddie tax, long-term capital gains that exceed the tax-free threshold will be taxed at the parents’ tax rate instead of the child’s lower rate. Families should consider holding investments longer to reduce taxable transactions and delay potential tax liabilities.

Custodial Accounts (UGMA/UTMA)

Custodial accounts such as UGMA (Uniform Gifts to Minors Act) and UTMA (Uniform Transfers to Minors Act) allow parents to transfer assets to their children. While these accounts provide flexibility in using funds for any purpose, they generate unearned income that may be subject to the kiddie tax.

If a custodial account accrues dividends, interest, or capital gains, those earnings are considered part of the child’s taxable income. Families may consider shifting funds from custodial accounts into 529 plans to reduce the tax burden, where earnings grow tax-free if used for educational expenses.

Strategies to Minimise or Avoid Kiddie Tax

529 College Savings Plans

Investing in a 529 plan can help avoid kiddie tax issues while providing tax-free growth for education expenses. Since withdrawals used for qualifying education costs are not taxed, they offer a tax-efficient savings option.

Shifting Investments to Low-tax Assets

Certain types of investments generate little to no taxable income. These include:

• Municipal bonds – Interest earned is tax-free at the federal level and may be exempt from state taxes.
• Index funds often have lower turnover rates, resulting in fewer taxable capital gains distributions.
• Growth stocks – Stocks that do not pay dividends allow families to defer taxes until the stock is sold.

Deferring Investment Gains

By holding assets longer, families can delay capital gains tax liability. Selling assets strategically when the child is no longer subject to the kiddie tax can help avoid higher tax rates.

Gifting Strategies

If parents intend to transfer wealth, waiting until the child exceeds the kiddie tax age limit can help avoid unnecessary taxation. Once a child reaches 24 years old (if a full-time student) or earns their own support, unearned income is taxed at normal rates instead of the parents’ marginal tax rate.

Encouraging Earned Income

Children with earned income (e.g., wages from part-time jobs) are taxed at standard rates rather than facing kiddie tax implications. Encouraging children to take up part-time employment can help balance their taxable income and reduce the impact of unearned income taxation.

Common Misconceptions about Kiddie Tax

Kiddie Tax Applies to All Children

Not all children are subject to the kiddie tax. It only applies if they receive unearned income exceeding the threshold and are classified as dependents. If a child earns more than half of their financial support, they are exempt.

Parents Can Avoid Kiddie Tax by Gifting Assets

Gifting assets into a child’s name does not eliminate tax liability. If those assets generate unearned income, the child remains subject to kiddie tax rules. Proper tax planning is required to manage investments effectively.

All Student Earnings are Taxed Under Kiddie Tax Rules

The kiddie tax only applies to unearned income. Wages, salaries, and self-employment earnings are taxed under regular income tax brackets, separate from the kiddie tax regulations.

FAQs

Does the kiddie tax apply to all children with investment income?

No, it applies only to dependent children under 19 or full-time students under 24 with unearned income exceeding the threshold. If a child provides more than half of their financial support, they are exempt from kiddie tax rules.

How can parents legally reduce their child’s kiddie tax liability?

Parents can invest in 529 college savings plans, choose tax-efficient investments like municipal bonds, and encourage children to earn income. Delaying the sale of assets until the child is no longer subject to the kiddie tax can also help reduce tax liabilities.

What types of income are subject to the kiddie tax?

The kiddie tax applies to unearned income, including interest, dividends, capital gains, and custodial account earnings. Earned income, such as wages and salaries, is taxed under normal income tax brackets and is not subject to the kiddie tax.

Can a child file their own tax return to avoid the kiddie tax?

No, even if a child files their tax return, the IRS requires them to use Form 8615 if they have unearned income exceeding the threshold. Parents can also report their child’s income on Form 8814, which does not eliminate the kiddie tax.

What happens if a child receives investment income from a trust?

If a child is the beneficiary of a trust, unearned income distributions may be subject to kiddie tax rules. The tax treatment depends on the type of trust and whether the income is distributed or retained within the trust for future use.