Kiddie Tax

The Kiddie Tax was enacted by Congress as a part of the Tax Reform Act of 1986 to stop parents from utilizing a tax loophole that allowed them to avoid paying taxes on their taxable income by transferring it into the names of their children. Prior to then, investments made by minors were taxed at a lesser rate.

The kiddie tax is a set of income tax laws that apply to those under the age of 18 and full-time students under the age of 24. If the child's unearned income (investment income) exceeds the kiddie tax threshold for the tax year, the excess is subject to the kiddie tax and is taxed at the parents' marginal tax rate rather than the child's tax rate. Every year, the child tax threshold is updated by inflation.

The Kiddie Tax is not applicable if the child received a salary or wages from employment; in such case, the income was taxed at the child's rate. Kiddie tax will still be applied to the child's unearned income even if the requirements are met.

Understanding Kiddie Tax

The kiddie tax was established in 1986 in an effort to stop parents from using stock gifts to their children (or dependents) as a means of evading federal income tax. Children under the age of 18 or dependents enrolled full-time in school from 19 to 24 years old are covered by this law. To avoid paying the same marginal income tax rate as their parents, a child's unearned income must be less than $1,150 under the kiddie tax.

It's crucial for parents to comprehend how the kiddie tax affects their giving and stock transfer strategies. You may improve your asset management strategy for tax deductions and your overall gifting strategy by being aware of who is subject to the kiddie tax and current tax laws.

1. The kiddie tax places a cap on the amount of unearned income a dependent can have annually before it becomes taxable.
2. Depending on the overall unearned income, the kiddie tax increases.
3. If your dependent meets certain requirements, you might not be required to report unearned income for them.

How To Calculate Kiddie Tax

Finding the child's taxable income is the first step in calculating the kiddie tax.

Child’s Net Earned Income + Child’s Net Unearned Income – Child’s Standard Deduction = Child’s Taxable Income

How Kiddie Tax works

The kiddie tax is applied to those under a specific age (18 years old or less, and full-time students between the ages of 19 and 24), whose investment and unearned income exceeds a threshold that is set annually.

The purpose of this regulation is to stop parents from abusing a tax deduction by giving their kids substantial stock presents. In this scenario, the child would then realize any investment profits and would be taxed at a rate that is significantly lower than the rate the guardians pay for their realized stock gain taxes.

The kiddie tax is a law that taxes all unearned income above a certain threshold at the parent's marginal income tax rate rather than the child's. Unearned income that is less than $1,100 in 2021 is eligible for the standard deduction. Anything over $2,200 is subject to taxation at the guardian's tax rate, which may be as high as 37%. The child's tax rate applies to the first $1,100, which is very low—sometimes 0%—and everything after that.

In 2022, unearned income up to $1,150 is exempt from taxation, and the subsequent $1,150 is subject to the child tax rate.

Key Takeaways

The kiddie tax stops parents from transferring sizable stock gifts to avoid paying taxes. Over the threshold, all unearned income is taxed at the parent's marginal rate rather than the lower child rate.

All children under the age of 18 and dependent full-time students between the ages of 19 and 24 are covered by this. The kiddie tax does not apply to any salary or wages; rather, it affects the majority of unearned income that a child receives.

Unearned income of less than $1,150 in 2022 is eligible for the standard deduction under the child tax legislation.