What Is the Kiddie Tax and How Does It Work?

The “kiddie tax” is a specific tax rule designed to prevent high-income individuals from reducing their tax liability by transferring income-generating assets to their children, who might otherwise be in a lower tax bracket. This tax ensures that a child’s unearned income exceeding a certain amount is taxed at the parent’s marginal tax rate, rather than the child’s typically lower rate.

Understanding Who and What Income is Subject to the Kiddie Tax

The kiddie tax applies to children who meet specific age and income criteria. For the 2023 tax year, this includes children who were under 19 years old at the end of the year. It also applies to full-time students between the ages of 19 and 23 at the end of the tax year, provided their earned income did not exceed half of their total support.

The tax specifically targets “unearned income,” which is income not generated from work, services, or business activities. Common examples of unearned income include interest from savings accounts, dividends from stocks, and capital gains from the sale of investments. It also encompasses rents, royalties, taxable scholarships and fellowships not reported on a W-2, and distributions from trusts or Uniform Gifts/Transfers to Minors Act (UGMA/UTMA) accounts.

Income sources like wages, salaries, tips, or other compensation for personal services are considered “earned income” and are not subject to the kiddie tax. There are also specific exceptions where the kiddie tax does not apply, even if the age and unearned income criteria are met. These exceptions include situations where the child files a joint tax return as married, if the child’s earned income is greater than half of their support, or if both parents are deceased at the end of the tax year.

Determining the Kiddie Tax Amount for 2023

For the 2023 tax year, specific thresholds determine how a child’s unearned income is taxed under the kiddie tax rules. The first $1,250 of a child’s unearned income is generally tax-free, benefiting from a standard deduction. The next $1,250 of unearned income is taxed at the child’s own ordinary income tax rate.

Any unearned income exceeding this combined threshold of $2,500 is then taxed at the parents’ marginal income tax rate. The parent’s marginal tax rate is determined by their tax filing status, such as single, married filing jointly, or married filing separately.

To illustrate, consider a dependent child in 2023 with $4,000 in unearned income and no earned income. The first $1,250 of this income is tax-free. The next $1,250 (bringing the total to $2,500) would be taxed at the child’s individual income tax rate. The remaining $1,500 ($4,000 total unearned income minus the $2,500 threshold) would then be subject to the parents’ marginal tax rate.

Reporting Kiddie Tax Income on Tax Returns

When a child’s unearned income falls under the kiddie tax rules, there are two main methods for reporting it on tax returns. The most common method involves the child filing their own tax return, usually Form 1040, and attaching Form 8615, “Tax for Certain Children Who Have Unearned Income.” Form 8615 is used to calculate the tax on the child’s unearned income that is subject to the parent’s tax rate.

To complete Form 8615, information such as the child’s name and Social Security Number, along with the parent’s name, Social Security Number, and filing status, is required. The form calculates the child’s net unearned income, determines how much is subject to the kiddie tax, and then computes the tax based on the parent’s tax rate.

An alternative option, available under specific conditions, allows parents to elect to report their child’s unearned income on their own tax return using Form 8814, “Parents’ Election To Report Child’s Interest and Dividends.” This election can be made if the child’s only income is from interest and dividends, the gross income is below a certain threshold (e.g., less than $13,000 for 2023), and no estimated tax payments were made in the child’s name. Using Form 8814 can simplify the filing process by eliminating the need for a separate tax return for the child.

However, parents should be aware that including the child’s income on their return could increase their Adjusted Gross Income (AGI), which might affect other deductions or credits they are eligible for. Information needed for Form 8814 includes the child’s name, Social Security Number, and the total amount of their interest and dividends. Once the appropriate forms are completed, they are attached to the relevant tax return and submitted, either electronically or by mail, to the Internal Revenue Service.