Kiddie tax

What Is Kiddie Tax?

The Kiddie Tax is a specialized set of U.S. federal income tax rules designed to prevent high-income individuals from minimizing their tax liability by shifting investment income to their children, who might otherwise be subject to lower tax brackets. It falls under the broader category of Taxation. This provision primarily applies to a child's unearned income, such as dividends, interest income, and capital gains. The core principle of the Kiddie Tax is that unearned income exceeding a certain threshold is taxed at the parent's marginal income tax rate, rather than the child's typically lower rate.

History and Origin

Before the enactment of the Kiddie Tax, parents in higher income brackets could transfer income-generating assets, such as stocks or bonds, into their children's names. The income from these assets would then be taxed at the child's significantly lower tax rate, effectively reducing the family's overall tax burden. To counter this tax avoidance strategy, the U.S. Congress introduced the Kiddie Tax as part of the Tax Reform Act of 1986.³¹,³⁰

Initially, the Kiddie Tax applied to children under the age of 14, targeting income that was presumed to be primarily from parental gifts rather than the child's own labor. Over the years, the rules evolved. The Tax Increase Prevention and Reconciliation Act of 2006 and the Small Business Work Opportunity and Tax Act of 2007 broadened its scope, extending the age limit to dependents under 18, and then to those under 19, or under 24 if they were full-time students.²⁹ While the Tax Cuts and Jobs Act (TCJA) of 2017 temporarily changed the Kiddie Tax rates to those applied to trusts and estates, the SECURE Act retroactively reinstated the original parent's tax rate calculation for tax years beginning after 2019.²⁸

Key Takeaways

• The Kiddie Tax aims to prevent parents from using lower children's tax rates to reduce their family's total tax burden on investment income.
• It applies to unearned income (e.g., interest, dividends, capital gains) of eligible children, not earned income from wages or salaries.
• The tax generally applies to children under 18, 18-year-olds whose earned income does not exceed half their support, and full-time students aged 19-23 whose earned income does not exceed half their support.
• Unearned income above an annually adjusted threshold is taxed at the parents' marginal income tax rate.
• Reporting the Kiddie Tax often involves filing IRS Form 8615, "Tax for Certain Children Who Have Unearned Income."²⁷

Formula and Calculation

The calculation of the Kiddie Tax involves specific thresholds that are adjusted annually for inflation. For the 2025 tax year (taxes filed in 2026), the unearned income rules for children subject to the Kiddie Tax are as follows:

• The first $1,350 of a child's unearned income is tax-free, covered by a portion of the standard deduction.²⁶,²⁵,²⁴
• The next $1,350 of unearned income is taxed at the child's own tax rate.²³,²²,²¹
• Any unearned income exceeding $2,700 is taxed at the parents' marginal tax rate.²⁰,¹⁹,¹⁸

The general formula to determine the amount of unearned income subject to the parent's tax rate is:

Using 2025 thresholds:

The calculation often requires completing IRS Form 8615, "Tax for Certain Children Who Have Unearned Income," which is attached to the child's Form 1040 tax return.¹⁷,¹⁶ This form considers the parents' taxable income to determine the applicable rate for the child's excess unearned income.

Interpreting the Kiddie Tax

Interpreting the Kiddie Tax primarily involves understanding which portion of a child's income is subject to these special rules and at what rate it will be taxed. It is crucial to distinguish between earned income and unearned income, as the Kiddie Tax exclusively applies to the latter. Earned income, such as wages from a summer job, is always taxed at the child's own tax rate, regardless of the amount. Unearned income, however, triggers the Kiddie Tax once it surpasses the annual threshold.

The purpose of the Kiddie Tax is to ensure fairness in the tax system by preventing income shifting. If a child's unearned income significantly exceeds the threshold, the impact of the Kiddie Tax can be substantial, as the excess is taxed at the parents' often higher marginal rate. This means that while a child may technically own the assets generating the income, the tax implications are tied to the parents' financial situation. Families should review their investment strategies involving minors, especially those with custodial accounts, to anticipate potential Kiddie Tax implications.

Hypothetical Example

Consider a hypothetical scenario for the 2025 tax year:

Samantha is 16 years old and is not a full-time student. She received $4,500 in unearned income from stock dividends and bond interest held in a Uniform Gifts to Minors Act (UGMA) account. Samantha has no earned income. Her parents are in the 35% marginal tax bracket.

Here's how the Kiddie Tax would apply:

1. First tier (tax-free): The first $1,350 of Samantha's unearned income is tax-free due to the standard deduction.
2. Second tier (child's rate): The next $1,350 of her unearned income is taxed at Samantha's own tax rate (e.g., 10%).
3. Third tier (parent's rate): The remaining unearned income is subject to the Kiddie Tax and will be taxed at her parents' marginal rate.
   • Unearned income subject to parent's rate = Total Unearned Income - (First Tier + Second Tier)
   • Unearned income subject to parent's rate = $4,500 - ($1,350 + $1,350) = $4,500 - $2,700 = $1,800

In this example, $1,800 of Samantha's unearned income would be taxed at her parents' 35% marginal rate, while the first $2,700 would be taxed at her own lower rates or be tax-free.

Practical Applications

The Kiddie Tax has several practical implications for personal finance and estate planning. For families with significant investment assets, understanding these rules is essential for efficient financial management.

• Investment Planning: The Kiddie Tax influences decisions about gifting appreciated assets to minors. While transferring assets can still be a valuable tool for long-term wealth transfer, the tax implications on income generated by these assets must be carefully considered. Financial advisors often guide families on strategies that may minimize the impact of the Kiddie Tax, such as investing in growth stocks that pay minimal dividends or in tax-advantaged accounts like 529 plans or Roth IRAs, which are generally exempt from Kiddie Tax rules.
• Tax Compliance: Parents and guardians are responsible for ensuring compliance with Kiddie Tax rules. This often involves filing IRS Form 8615, which computes the child's tax based on the parents' tax information. In some cases, parents may elect to report a child's interest and dividends on their own return using Form 8814, simplifying the filing process, though this option has specific requirements and limitations.¹⁵
• Education Planning: While 529 college savings plans are popular for educational funding, their growth and withdrawals for qualified education expenses are generally not subject to the Kiddie Tax, making them an attractive alternative for saving for a child's future.¹⁴
• Age and Income Thresholds: Remaining aware of the annually adjusted unearned income thresholds and the specific age and student status criteria for the Kiddie Tax is crucial for ongoing financial planning. The Internal Revenue Service (IRS) provides detailed guidance on these thresholds and who must file Form 8615.¹³

Limitations and Criticisms

Despite its intent to prevent tax avoidance, the Kiddie Tax has faced criticisms for its complexity and unintended consequences. One significant limitation is the increased compliance burden it places on taxpayers. Calculating the tax often requires parents to share their financial information with their children or their tax preparers, which can raise privacy concerns, especially as the age limits have extended to older students who may be financially independent in many respects.¹²

Furthermore, the complexity is compounded for families with multiple children subject to the tax, or in cases of divorce or separation, where determining which parent's income to use can become challenging.¹¹ While the tax aims to simplify tax administration by preventing income shifting, the rules themselves can be intricate to navigate, requiring detailed worksheets and an understanding of specific income types. The IRS offers publications to help taxpayers understand these rules, such as IRS Topic No. 553, "Tax on a Child's Investment and Other Unearned Income (Kiddie Tax)," yet the nuances can still be difficult for non-experts.¹⁰,⁹

Kiddie Tax vs. Unearned Income

The terms "Kiddie Tax" and "Unearned Income" are closely related but refer to distinct concepts within tax law. Unearned income is any income derived from sources other than wages, salaries, or other compensation for services performed. Common examples include interest income from savings accounts or bonds, dividends from stocks, and capital gains from the sale of investments. This type of income is generally subject to federal income tax regardless of who receives it.

The Kiddie Tax, however, is a specific rule that applies to a portion of a child's unearned income. It is not a tax on all unearned income a child receives. Instead, it is a mechanism that dictates the tax rate applied to unearned income that exceeds certain statutory thresholds for qualifying children. Without the Kiddie Tax, all of a child's unearned income would be taxed at their own, typically lower, marginal income tax rate. The Kiddie Tax ensures that qualifying unearned income above the threshold is taxed at the parent's marginal tax rate, effectively preventing the use of children's lower rates for substantial investment income.

FAQs

Q: What is considered unearned income for Kiddie Tax purposes?

A: For Kiddie Tax purposes, unearned income includes taxable interest, ordinary dividends, capital gains (including capital gain distributions), rents, royalties, and other investment income. It does not include income from a child's employment, such as wages or salaries.⁸,⁷

Q: What are the age limits for the Kiddie Tax?

A: The Kiddie Tax generally applies to:

• Children under age 18 at the end of the tax year.
• 18-year-olds whose earned income does not exceed half of their support.
• Full-time students aged 19 through 23 whose earned income does not exceed half of their support.⁶,⁵

Q: Can a parent elect to include a child's income on their own tax return?

A: Yes, in some cases, parents can elect to include a child's interest and dividend income on their own tax return using IRS Form 8814, "Parents' Election To Report Child's Interest and Dividends." This option is typically available if the child's only income is from interest and dividends (including capital gain distributions) and it falls below a certain threshold (e.g., less than $13,000 for 2024). This election simplifies filing but may increase the parents' Adjusted Gross Income and potentially their tax liability.,⁴

Q: Does the Kiddie Tax apply to income from a child's job?

A: No, the Kiddie Tax does not apply to earned income, which is income from wages, salaries, or other compensation for services performed. This type of income is taxed at the child's own tax rate. The Kiddie Tax is specifically designed for unearned income from investments.³,²

Q: Are there ways to avoid or minimize the Kiddie Tax?

A: Strategies to avoid or minimize the Kiddie Tax often involve investing in assets that generate minimal current unearned income, such as growth-oriented stocks or certain tax-exempt bonds. Utilizing tax-advantaged accounts, such as 529 college savings plans or Roth IRAs (if the child has earned income), can also help, as income within these accounts is generally not subject to the Kiddie Tax if used for qualified expenses. Consulting a tax professional for personalized advice is recommended.¹