Tips to Minimize the Kiddie Tax

The "kiddie tax" prevents parents from shifting income-producing assets to children to take advantage of their lower tax rate. It was introduced as part of the Tax Reform Act of 1986. Before this law, high-income parents and other family members could divert some investment income and gains to younger family members, who could then pay federal income taxes at lower rates.

Under today's kiddie tax rules, to the extent a child's net unearned income exceeds the annual threshold, it can be taxed at the parent's higher marginal federal income tax rate. A child can potentially be hit with the kiddie tax until the year he or she turns 24. For simplicity, this article refers to anyone affected by the kiddie tax as a "child," even if they'd be considered an adult for legal and other purposes.

Kiddie Tax Basics  

The kiddie tax rules can cause a portion of an affected child's net unearned income to be taxed at the parent's higher marginal federal rate rather than at the child's lower federal rate. Specifically, the portion of a child's taxable income comprising net unearned income above the annual threshold is potentially subject to the kiddie tax.

For 2024, the annual unearned income threshold is $2,600. The kiddie tax doesn't affect children with net unearned income for 2024 below that threshold.

More specifically, the kiddie tax applies when all the following requirements are met for the tax year:

• The child doesn't file a joint return for the year.
• One or both parents are alive at the end of the year.
• The child's net unearned income for the year exceeds the threshold for that year, and the child has positive taxable income after subtracting any allowable write-offs, such as the standard deduction.
• The child falls under one of three age categories: 1) the child is 17 or younger at year end, 2) the child is 18 at year end and doesn't have earned income that exceeds half of his or her support (excluding any amounts received as scholarships), or 3) the child is age 19 through 23 at year end and is a full-time student who doesn't have earned income that exceeds half of his or her support (excluding any amounts received as scholarships).

A child is considered to be a student if he or she attends school full-time for at least five months during the year.

For instance, Liana turned 19 on August 8, 2024. She's a full-time student for the year. Her earned income for 2024 doesn't exceed half of her support (excluding any amounts received as scholarships). Liana will be subject to the kiddie tax for 2024 if the other three requirements are also met. If Liana wasn't a student for 2024, she'd be exempt from the kiddie tax. But she'll be exposed to the kiddie tax in 2025 through 2028 if she's a full-time student for any of those years, because she'll be under age 24 for those years.

Calculating the Kiddie Tax

To calculate federal income tax for a child under the kiddie tax rules, first add up the child's net earned income and net unearned income. Then, subtract the child's standard deduction and other allowable deductions to arrive at taxable income.

For 2024, the standard deduction for a dependent child (meaning one who doesn't pay for more than 50% of his or her support) is the greater of:

• $1,300, or
• Earned income plus $450, not to exceed the regular standard deduction of $14,600.

The portion of a child's taxable income that consists of net earned income is taxed at the regular rates for a single taxpayer, assuming the child isn't married. The kiddie tax will hit the portion of taxable income comprising net unearned income and exceeding the annual unearned income threshold ($2,600 for 2024).

Beating the Kiddie Tax

The kiddie tax can be expensive for young people with substantial unearned income. The higher the marginal parental tax rate, the more expensive the kiddie tax will be. Here are some suggestions to minimize or avoid the kiddie tax: 

Exploit the unearned income threshold. The kiddie tax applies only when the child has unearned income above the threshold for that year ($2,600 for 2024). In later years, the threshold will be adjusted periodically for inflation.

For example, Hannah is a 20-year-old full-time college student in 2024. Her parents provide over half of her support, so she's their dependent. For 2024, she has no earned income, but she has $3,000 of interest income from CDs held in a custodial account that her parents set up for her. The kiddie tax applies to Hannah for 2024 because her net unearned income exceeds the $2,600 threshold for the year. However, only $400 ($3,000 minus $2,600) will be taxed at her parents' higher marginal federal income tax rate.

Generate earned income. The kiddie tax doesn't affect individuals who are age 18 to 23 if their earned income exceeds 50% of their support for the year. But they aren't required to actually spend any of their earned income on support. So, your child could save all his or her earned income (or put it into a college fund) and still pass the more-than-50%-support test. When a child isn't the parent's dependent for the year because he or she provides over half of his or her own support, the child can claim the full standard deduction ($14,600 for 2024).

Pick the right investments. Even when the child owns significant investment assets, the kiddie tax can often be avoided or minimized by picking the right investments. For example, growth stocks with minimal turnover can be a tax-smart asset to transfer to kids. These investments typically won't generate much unearned income because most growth companies pay only modest dividends, or no dividends at all. The kiddie tax won't hit dividends and gains up to the annual unearned income threshold ($2,600 for 2024).

Suppose the dividends and gains of a child's investments are poised to significantly exceed the unearned income threshold. In that case, you might consider selling some underperforming stocks in the child's portfolio before year end. Doing so will trigger capital losses to offset the unearned income and potentially get closer to the unearned income threshold for the year. This could help reduce or avoid the kiddie tax hit.

Another tax-smart strategy is to hold growth stocks or tax-efficient mutual funds until the child is exempt from the kiddie tax (after graduating from college or reaching age 25). If the assets are sold after the individual is exempt, the long-term capital gains will be taxed at his or her federal income tax rate, which could be as low as 0%. 

Use college savings tools. Instead of transferring assets to a child, consider contributing them to a Section 529 college savings plan. Qualified withdrawals from a Sec. 529 account are federal-income-tax-free. Tax-free withdrawals aren't subject to kiddie tax, even when the child owns the account.

Life insurance products that include investment accounts (such as universal life policies and other types of whole life policies) can also be effective college savings vehicles. If the insured person (usually a parent) dies prematurely, the death benefit payment can be used to complete the child's college savings program. Death benefit payments are federal-income-tax-free whether the parent or the college-bound child owns the policy. In addition, the cash value of a life insurance policy's investment account is allowed to build up on a tax-deferred basis until the money is withdrawn. Meanwhile, the parent can borrow against the cash value to help cover the child's college costs.

Kiddie Tax Rules Aren't Child's Play

The kiddie tax rules are complicated. However, experienced tax professionals understand the ins and outs and can help implement strategies to minimize or avoid the kiddie tax hit. Contact your SSB tax advisor for more information.

©  2024