How to Avoid the Kiddie Tax: Rules and Strategies

The kiddie tax prevents families from shifting investment income to children to take advantage of their lower tax rates. It applies a parent’s higher tax rate to a child’s unearned income, such as interest, dividends, and capital gains, once it exceeds a certain annual threshold. This tax specifically targets passive income, not money a child earns from a job, to ensure income from assets is taxed appropriately based on the family’s financial standing.

Understanding the Kiddie Tax Triggers

The kiddie tax applies based on age. It affects children under 18 at the end of the tax year. The rule also extends to children age 18, or full-time students aged 19 through 23, if their earned income does not cover more than half of their support for the year.

The tax is triggered if a child’s unearned income exceeds a specific threshold. For the 2025 tax year, this threshold is $2,700.

The $2,700 threshold for 2025 is part of a tiered system. The first $1,350 of unearned income is covered by the child’s standard deduction and is not taxed. The next $1,350 is taxed at the child’s own income tax rate. Only unearned income above the $2,700 total is taxed at the parent’s highest marginal tax rate.

Investment Strategies to Minimize Unearned Income

A primary method for managing the kiddie tax involves selecting investment vehicles that either defer or eliminate taxable unearned income. By choosing how a child’s assets are held, funds can grow without generating an annual tax liability subject to the parent’s higher rates.

• Use tax-advantaged education accounts like a 529 Plan or a Coverdell Education Savings Account (ESA). Contributions grow tax-deferred, so earnings within the account do not count as unearned income. Withdrawals are federally tax-free when used for qualified education expenses.
• Invest in municipal bonds. Interest paid by these bonds is exempt from federal income tax and does not contribute to the unearned income threshold.
• Focus on growth-oriented assets like stocks that reinvest profits rather than paying dividends. This minimizes annual unearned income, as the value grows through appreciation and tax is not due until the asset is sold. By holding these assets until the child is no longer subject to the kiddie tax, any capital gain can be taxed at the child’s lower rate.
• Purchase U.S. Savings Bonds, such as Series EE and Series I. The interest accrues but is not taxed until the bonds are cashed in. The accumulated interest can be realized after the child ages out of the kiddie tax provisions to be taxed at their individual rate.

Income and Timing Strategies

A family can legitimately employ a child in a family-owned business. Payments for services are considered earned income, not unearned, and are not subject to the kiddie tax. This income is taxable to the child but is offset by their standard deduction, which is based on their earned income.

The compensation must be reasonable for the work performed, and the tasks must be necessary for the business. Maintain clear records like timesheets and issue a Form W-2. If the business is a sole proprietorship or a parent-owned partnership, wages paid to a child under 18 are also exempt from FICA taxes, and wages to a child under 21 are exempt from FUTA taxes. This payroll tax exemption does not apply if the business is a corporation or a partnership with non-parent partners.

Timing the sale of assets is another strategy. If a child holds an appreciated investment, selling it could create a large capital gain taxed at the parent’s rate. By waiting to sell the asset until the child is older, such as age 24 and no longer a full-time student, the gain will be taxed at the child’s individual capital gains rate.

How to Report a Child’s Unearned Income

The standard method is for the child to file their own tax return using Form 1040. They must also attach Form 8615, Tax for Certain Children Who Have Unearned Income. This form uses the parent’s tax information to calculate the tax on the child’s unearned income, which is then paid with the child’s return.

Parents may elect to report their child’s income on their own return by filing Form 8814, Parents’ Election to Report Child’s Interest and Dividends. This option is only available if the child’s income consists solely of interest and dividends and is below a certain limit. While this avoids a separate return for the child, it increases the parent’s adjusted gross income (AGI), which could affect other deductions or credits.