Cutting the Kiddie Tax Down to Size

Despite its name, the "kiddie tax" is anything but child's play. If you're not careful, this provision of the tax code can result in children having to pay significant extra tax dollars on their investment income. But your family may be able to downsize the kiddie tax for 2023 by making the right tax moves before year end.

For simplicity, throughout this article we use the terms "child" and "children" to apply to both children and young adults under age 24 who may be subject to the kiddie tax.

Background

Generally, income is taxed at the tax rate of the individual who receives it. For example, if you're in the top 37% tax bracket in 2023, any additional income you earn is taxed at the 37% rate. On the other hand, if your child is in the 10% bracket, the child pays tax at a maximum rate of only 10%. 

However, a special rule applies to certain children who receive unearned income above an annual threshold. Under current law, the excess is taxed at the top marginal tax rate of the child's parents. Thus, instead of being taxed at the 10% rate, your child may be taxed at the 37% rate on the excess.

Unearned income includes the following types of income a child might receive during the year:

• Taxable interest,
• Capital gains,
• Dividends,
• Income produced by custodial accounts, and
• Taxable scholarships.

The source of the income doesn't matter. For instance, unearned income resulting from gifts of property by grandparents counts toward the kiddie tax. However, the tax doesn't apply to earned income, such as wages from a part-time job.

Initially, the kiddie tax only applied to children under 14, but the limit has been raised several times. Currently, the age limit is 19 (24 for a full-time student if the child doesn't have earned income in excess of half of their annual support). In other words, if your dependent child is in college, the kiddie tax likely still applies.

Important: The Tax Cuts and Jobs Act temporarily changed the way the kiddie tax was calculated. Previously, instead of using the parents' top tax rate, the tax was based on the income tax rates for trusts and estates. But Congress repealed this change under the SECURE Act of 2019.

The annual kiddie tax threshold is adjusted for inflation. For 2023, the first $1,250 is exempt from tax and the next $1,250 is taxed at the 10% rate. Therefore, the total kiddie tax threshold is $2,500. For example, if your 18-year-old has $5,000 in investment income in 2023, the first $1,250 is tax-free, the second $1,250 is taxed at 10% and the remainder ($2,500) is taxed at your marginal effective tax rate. 

6 Tax Reduction Strategies

By being proactive, you can reduce your kiddie tax liability—or possibly eliminate it entirely. Consider the following six strategies:

1. Keep tabs throughout the year. For instance, if your child is approaching the $2,500 threshold, defer capital gains to next year. Similarly, you might hold off on gifts of income-producing property until your child is older.
2. Emphasize tax-deferred investments for your child. This may include growth stock, U.S. savings bonds, certificates of deposit and Treasuries that won't mature until next year or later.
3. Establish a Roth IRA for your child. For 2023, kids with jobs can contribute up to the lesser of $6,500 or their earned income. Subsequently, amounts can be withdrawn tax-free in retirement. (However, withdrawals before age 59½ will be subject to a 10% penalty unless an exception applies.)  
4. Consider a Section 529 plan account for your child's investment earnings. Distributions used to pay for qualified higher education expenses are exempt from tax. Also, many states provide state tax benefits for contributions to Sec. 529 plans.
5. Allocate some of your child's portfolio to municipal bonds or muni bond funds. Generally, the income received from these investments is free of federal income tax, so any current income won't trigger the kiddie tax.
6. Hire your high schooler or college student to work for your company. Because wages constitute earned income, this won't trigger any kiddie tax complications. If the child is paid a reasonable salary for services performed, your company can deduct the wages. This is a tax-wise way to help a child save money for college, plus it instills a sense of financial responsibility and independence.

How to Report the Tax

Many parents elect to report the kiddie tax on their own returns to simplify matters. If you make this election for 2023, your child won't have to file a tax return next year. If you're unable or unwilling to make this election, your child will be required to file a return if he or she receives unearned or earned income.

You must meet the following seven requirements to be eligible for this election:

1. Your child was under 19 (or under 24 if a full-time student) at the end of the tax year.
2. Your child's gross income was less than $11,500 for the tax year.
3. Your child had income only from interest and dividends (including capital gain distributions and Alaska Permanent Fund dividends).
4. No estimated tax payments were made for your child for the tax year, and no overpayment from the previous tax year (or from any amended return) was applied to the current tax year under your child's name and Social Security number.
5. No federal income tax was withheld from your child's income under the backup withholding rules.
6. Your child doesn't file a joint return for the tax year.
7. You're the parent qualified to make the election, or you file a joint return with your child's other parent.

We Can Help

Don't let the kiddie tax catch your family off-guard. If your child or grandchild has significant unearned income, contact your SSB tax advisor to identify strategies that will help reduce the kiddie tax for 2023 and beyond.

©  2023