What Is Unearned Income for a Child and How Is It Taxed?

Understanding how unearned income is taxed for children is critical for families aiming to optimize their tax strategy. Unearned income, such as interest and dividends, comes with tax implications that differ from earned income like wages. Tax regulations surrounding a child’s unearned income can affect a family’s overall tax liability, making it essential to understand the rules and requirements.

Common Categories of Income

Unearned income for children can come from various sources, each with distinct tax implications that influence financial planning strategies.

Interest

Interest income typically accrues from savings accounts, certificates of deposit (CDs), or bonds. This income is reported on Form 1099-INT and taxed as ordinary income. For 2023, the first $1,150 of unearned income may qualify for a standard deduction. Any income beyond this threshold could trigger the Kiddie Tax, depending on the total unearned income. Accurate record-keeping is vital for compliance and exploring tax-efficient investment options, such as municipal bonds, which may offer tax-exempt interest.

Dividends

Dividend income arises from shares in dividend-paying stocks or mutual funds. Dividends are categorized as qualified or non-qualified. Qualified dividends are taxed at favorable capital gains tax rates (0% to 20%, depending on income), while non-qualified dividends are taxed at the child’s ordinary income rate. Reviewing the types of dividends in a child’s portfolio and prioritizing investments generating qualified dividends can improve tax outcomes.

Capital Gains

Capital gains occur when an asset, such as stocks or real estate, is sold for more than its purchase price. Short-term gains (assets held for less than a year) are taxed at ordinary income rates, while long-term gains (assets held over a year) benefit from lower tax rates of 0% to 20% in 2023. Families can time asset sales to qualify for long-term capital gains treatment and use strategies like tax-loss harvesting to offset gains and minimize tax liability.

Royalties

Royalties come from the use of intellectual property, such as books or patents. They are typically reported on Form 1099-MISC and taxed as ordinary income. Families can explore structuring options, such as trusts, to optimize tax treatment and protect intellectual property. Tracking related expenses can also provide opportunities for deductions, reducing taxable income.

Trust Distributions

Trust distributions can be a substantial source of unearned income for children. Taxation depends on the trust type—simple or complex. In simple trusts, income is distributed annually and taxed to the beneficiary, while complex trusts may retain income, leading to taxation at the trust level. Understanding the trust’s structure and distribution policies is crucial for managing tax liabilities. Consulting a tax advisor can help navigate the complexities of trust distributions effectively.

Tax Filing Requirements

For the 2024 tax year, if a child’s unearned income exceeds $1,300, a separate tax return may be required. This threshold is adjusted annually for inflation. Filing requirements also depend on factors like the child’s age and marital status.

The IRS requires unearned income to be reported on Form 8615, which calculates tax owed using the parents’ marginal tax rate. Failure to file this form when necessary can result in penalties. In some cases, parents can report their child’s unearned income on their own return using Form 8814. This option is available if the income is solely from interest and dividends and remains below $11,000 for 2024. However, this choice may eliminate certain tax benefits, such as the child’s standard deduction.

The Kiddie Tax

The Kiddie Tax is designed to prevent families from shifting investment income to children in lower tax brackets. It applies to children under 19—or full-time students under 24—with unearned income exceeding $2,300 in 2024. This income is taxed at the parents’ marginal rate, which can result in a higher tax liability.

Form 8615 is used to calculate the Kiddie Tax and requires details about the parents’ tax situation. Families can mitigate its effects by investing in tax-advantaged accounts like 529 plans, which grow tax-free if used for qualified education expenses. Shifting to investments yielding capital appreciation rather than dividends or interest may also help, as unrealized gains are not subject to the Kiddie Tax until the asset is sold.

Dependency Considerations

A child’s dependency status significantly affects tax implications for both the child and the parents. If a child is claimed as a dependent, families may qualify for benefits like the Child Tax Credit, which provides up to $2,000 per child in 2024. Accurate assessment of dependency status is essential, particularly the support test, which ensures the child does not provide more than half of their own support. Proper documentation of income and expenses is critical to substantiate dependency claims and avoid issues with the IRS.

Parental Reporting Options

Parents can opt to report a child’s unearned income on their own tax return using Form 8814, provided the income is solely from interest and dividends and below $11,000 for 2024. This option simplifies filing but eliminates the child’s standard deduction, potentially increasing taxable income. Additionally, the income is taxed at the parent’s marginal rate, which may result in a higher tax liability.

Parents should also consider the potential impact on their own taxable income, as including the child’s income might push them into a higher tax bracket, reducing eligibility for certain credits or deductions. State tax laws may further complicate this option, as some states require separate filings for the child regardless of federal reporting. Consulting a tax advisor can help families evaluate the financial implications and choose the best approach.