Which of These Individuals Would Be Subject to the Kiddie Tax?

The Kiddie Tax is a tax rule designed to prevent parents from shifting investment income to their children to take advantage of lower tax rates. It applies to unearned income, such as interest, dividends, and capital gains, received by certain individuals who meet specific criteria. This can result in a portion of a child’s income being taxed at the parent’s rate instead of the child’s lower rate.

Understanding who falls under the Kiddie Tax rules is important for families with investments held in a child’s name. Several factors determine if someone is subject to this tax, including age, dependency status, and the amount and type of unearned income they receive.

Age Criteria

The Kiddie Tax applies to children under 18 and certain young adults between 18 and 23 if they are full-time students. A full-time student is defined as someone enrolled in school for at least five months of the year.

For those under 18, the tax applies regardless of whether they have a job. Once an individual turns 18, the tax may still apply if they do not provide more than half of their own financial support. Even with a part-time job, they could be subject to the Kiddie Tax if their earnings are insufficient to cover most living expenses.

The rules extend to individuals up to age 23 if they are full-time students and financially dependent. However, once a person reaches 24, the Kiddie Tax no longer applies, even if they are still in school. This distinction is important for families planning for education expenses, as investment income in a child’s name could be taxed at higher rates if they fall within these age limits.

Dependent Requirements

For the Kiddie Tax to apply, the individual must be claimed as a dependent on someone else’s tax return. The IRS determines dependency based on financial support and residency. A child must live with the taxpayer for more than half the year, except in cases of temporary absences for school, medical care, or military service. Additionally, the child cannot provide more than half of their own financial support during the tax year.

Support includes housing, food, clothing, education, and medical care. Scholarships do not count as self-support, meaning a college student who relies on parental assistance and scholarship aid may still qualify as a dependent.

Dependency status also affects tax benefits beyond the Kiddie Tax. Parents who claim a child as a dependent may qualify for education credits, such as the American Opportunity Credit or Lifetime Learning Credit, which can reduce overall tax liability. However, if a child provides more than half of their own support, they may need to file their own tax return independently, potentially avoiding the Kiddie Tax but losing access to certain tax advantages available to dependents.

Unearned Income Threshold

The Kiddie Tax applies only if unearned income surpasses a specific threshold, which is adjusted annually for inflation. In 2024, the threshold is $2,600. The first $1,300 of a child’s unearned income is tax-free due to the standard deduction, while the next $1,300 is taxed at the child’s rate. Any amount exceeding $2,600 is taxed at the parent’s marginal rate.

For example, if a child receives $5,000 in unearned income, the first $1,300 is not taxed, the next $1,300 is taxed at the child’s rate, and the remaining $2,400 is taxed at the parent’s rate. If the parents are in the 35% tax bracket, this could result in an additional tax burden of $840 on that portion alone.

Types of Unearned Income

The Kiddie Tax applies specifically to unearned income, which includes investment returns and other passive earnings rather than wages or salaries. The most common sources include interest, dividends, and capital gains, each of which has unique tax treatment.

Interest

Interest income includes earnings from savings accounts, certificates of deposit (CDs), U.S. Treasury bonds, municipal bonds, and corporate debt instruments. Interest from municipal bonds is generally exempt from federal income tax but may still be considered when determining whether the Kiddie Tax applies.

For children with significant interest income, tax planning strategies such as investing in tax-exempt bonds or shifting assets to tax-advantaged accounts like a 529 plan can help reduce exposure to higher tax rates. Interest income is typically reported on Form 1099-INT, and failure to report it accurately can result in IRS penalties. If a child’s total unearned income exceeds the filing threshold, they may need to file their own tax return, even if they are still a dependent.

Dividends

Dividend income arises from stock ownership and mutual fund investments. Dividends are classified into two types: qualified and nonqualified. Qualified dividends, which meet specific IRS holding period requirements, are taxed at the preferential long-term capital gains rates of 0%, 15%, or 20%, depending on the taxpayer’s income level. Nonqualified dividends are taxed as ordinary income at the child’s or parent’s marginal tax rate.

For example, if a child receives $3,000 in qualified dividends, the first $1,300 is tax-free, the next $1,300 is taxed at the child’s rate, and the remaining $400 is taxed at the parent’s rate. If the parent is in the 24% tax bracket, this could result in an additional $96 in tax liability. Families with substantial dividend income in a child’s name may consider tax-efficient investment strategies, such as holding dividend-paying stocks in a Roth IRA or other tax-advantaged accounts to minimize exposure to the Kiddie Tax.

Capital Gains

Capital gains occur when an asset, such as stocks, bonds, or real estate, is sold for more than its purchase price. The tax treatment of capital gains depends on the holding period. Short-term capital gains, from assets held for one year or less, are taxed as ordinary income, while long-term capital gains, from assets held for more than a year, are taxed at preferential rates of 0%, 15%, or 20%.

For children subject to the Kiddie Tax, long-term capital gains exceeding the unearned income threshold are taxed at the parent’s rate. For instance, if a child sells stock for a $5,000 long-term gain, the first $1,300 is tax-free, the next $1,300 is taxed at the child’s rate, and the remaining $2,400 is taxed at the parent’s rate. If the parent is in the 32% tax bracket, this could result in an additional $768 in taxes.

Tax planning strategies, such as timing asset sales to stay below the Kiddie Tax threshold or using tax-loss harvesting to offset gains, can help reduce tax liability. Additionally, gifting appreciated assets to children may not always be beneficial if the Kiddie Tax applies, as the tax savings from shifting income to a lower bracket could be negated by the higher tax rate imposed under these rules.

Filing Obligations

When a child has unearned income that exceeds the Kiddie Tax threshold, they may be required to file their own tax return. The IRS requires a separate return if a dependent has more than $1,300 in unearned income after the standard deduction or if their total income—both earned and unearned—exceeds the filing requirement for dependents. Parents, however, have the option to report a child’s unearned income on their own tax return using Form 8814, but this is only allowed if the child’s income consists solely of interest and dividends and does not exceed $12,500.

Choosing whether to file a separate return or report the income on the parent’s return depends on various factors, including the parent’s tax bracket and potential deductions. If reported on the parent’s return, the child’s income is taxed at the parent’s highest marginal rate, which could increase overall tax liability. Filing a separate return may allow for better tax planning, especially if the child has deductions or credits that could offset some of their tax burden. However, doing so requires careful record-keeping and may result in additional administrative work, such as tracking estimated tax payments if the child’s investment income is substantial.