March 15, 2023
The Kiddie Tax has been around since the 1980s. It was first introduced in the Tax Reform Act of 1986. The tax code had been being abused by wealthy parents transferring their assets into accounts and stocks in their children's names to avoid higher taxes. The Kiddie Tax effectively ended this work-around.
What is the Kiddie Tax?
The Kiddie Tax places a limit on the amount of investment income that can be taxed at the dependent child’s taxable income rate. It applies to investment and other unearned income that is reported under the social security numbers of minors or full-time college students under age 24.
How is the Kiddie Tax Calculated?
The Kiddie Tax is based on the child’s taxable income, age and dependency status.
Who is Subject to the Kiddie Tax?
At the end of the year the child is:
- under 18;
- 18, but have earned income that totals less than 50% of their support;
- 19-24, but enrolled as a full-time student and have earned income that totals less than 50% of their support.
To calculate the taxable income, you must use the following formula for the child in question:
Net Earned Income + Net Unearned Income – Standard Deduction = Taxable Income*
Regarding unearned income in 2023, the first $1,150 of the taxable income is tax-free, as it qualifies for the standard deduction. The next $1,150 of unearned income is then taxed at the child’s income tax rate, which is usually much lower than the parents’ rate. If the child has unearned income higher than the $2,300 total of these two amounts, the overage would be taxed at the parents’ marginal tax rate.
To see how this plays out in a hypothetical example, let’s say Liz is 15 years old and makes $8,000 as a baking assistant. She also has a custodial account set up by her aunt which earned $4,500 in interest.
The standard deduction for Liz is the greater of $1,150 or $400 + the sum of her earned income, up to $13,850. As Liz earned $8,000, $8,400 is her standard deduction for the year.
While she won’t pay any taxes on her earned income, she will need to pay taxes on her unearned income at her tax rate and her parents’ marginal tax rate (for the sake of this example, 22%.)
Here’s what Liz’s tax liability looks like:
$8,000 (earned income) + $4,500 (unearned income) - $8,400 (standard deduction) = $4,100 (taxable income).
$4,100 (taxable income) - $1,150 (untaxed) - $1,150 (taxed at Liz’s rate of 10%) = $1,800 will be taxed at her parents’ rate of 22%.
*For more information on earned and unearned income for children, please refer to our article “When Should My Child File a Tax Return?”.
To keep your child from having to pay taxes on this overage, the parent(s) may elect to report the amount on their tax return if the child earned less than $11,500 in gross income and their income is comprised solely of ordinary dividends, interest, and capital gains distributions.
If the child has earned income, they may open a Roth IRA where they can contribute up to $6,500 in 2023. If the parents, or other parties, are saving for college educational costs, they may open up a 529 Account. These two forms of savings accounts are two of the few ways to avoid paying the Kiddie Tax and keep your child’s tax bill low since income generated in these accounts is not subject to the Kiddie Tax.
If you have any questions about how this may impact your specific tax situation, please contact your Faw Casson advisor.