What To Know About The Kiddie Tax – In 1986, a law was passed prohibiting parents from moving investments to their children’s names to avoid paying taxes. Previously, children’s assets were taxed at the child’s low rate, and some wealthy parents would pass investments to their children specifically to lower their tax liability. The legislation is known as the “kiddie levy” altered the laws. Most investment income for children under the age of 14 was taxed at the parent’s rate in the first edition of this statute, which went into effect in 1987, restricting the transfers’ value. The laws have been modified many times since then.
“The kiddie levy, which was introduced in 1986 to discourage parents from escaping taxes by giving their children large gifts of stock and other investments, has seen a flurry of reforms in recent years,” says Chris Manderfield, executive vice president at KeyBank.
Since then, the tax-free age for children has risen, and new laws went into force in 2018 and will be updated again in 2020. “Over time, the definition of who is subject to the tax has expanded, and it can now extend to dependents up to the age of 18 and college students aged 19 to 23,” says Sarah Shannonhouse, manager of tax practice and ethics at the American Institute of CPAs.
What Is the Kiddie Tax?
The “kiddie levy” is a tax on unearned income for children. “The kiddie tax applies if the child’s unearned income reaches $2,200,” says Michael Trank, a CPA and personal finance expert with Wertz & Company LLP in Irvine, California. The unearned income of the child comes from sources other than working. According to Trank, the child can obtain unearned income from inherited IRAs and taxable scholarships, as well as investment income from a custodial account.
Over $2,200 in unearned income, the child’s investment, and other unearned income are subject to the kiddie tax laws and taxed at the parent’s rate. The kiddie tax does not extend to any earnings from jobs taxed at the child’s status.
How Is the Kiddie Tax Calculated?
The child’s unearned income under $1,100 is not taxable under the kiddie tax rules for 2020; the next $1,100 is taxed at the child’s tax rate, and any unearned income above $2,200 is taxed at the parent’s tax rate.
“The child could file a tax return, or the parent could opt to have their child’s interest, ordinary dividends, and capital gains distributions reported on their return. The wages will be charged at the parent’s marginal tax rate in either case, “Manderfield agrees.
When a Child Needs to File a Separate Tax ReturnThe rules for filing a different tax return are based on how much money the child received from working and how much money they earned from investments.
In 2020, children who earned more than $12,400 in acquired and unearned income must file their income tax returns. If the child’s only source of income is interest, dividends, or capital gains distributions totaling less than $11,000, the parents will be able to include the child’s earnings on their tax return by filing Form 8814. According to Trank, a few other conditions are to be included on the parents’ tax return, including the child having no withholdings or projected tax prepayments, being under the age of 19 or 24 if a full-time student is not filing a joint return with a partner.
If the child is eligible, there are benefits and drawbacks to disclosing the child’s income on the parent’s tax return. “The profit is convenience; However, there are drawbacks,” says Trank, “such as potentially exposing the child’s income to the net investment income tax, the loss of the child’s itemized deductions, and a slight rise in tax. On capital gains and eligible dividends.”
See IRS Topic 553, Tax on a Child’s Investment and Other Unearned Income, and IRS Publication 929, Tax Rules for Children and Dependents, for more detail.
Redoing 2018 and 2019 Kiddie Tax ReturnsIn 2018 and 2019, the laws for children’s taxes were temporarily altered. The kiddie tax was based on the tax rates that apply to estates and trusts rather than the child’s parent’s tax rate under the Tax Cuts and Jobs Act. “As a result, from 2018 to 2019, dependents subject to kiddie tax laws may have theoretically been taxed at rates higher parent’s marginal tax rate,” Shannonhouse says.
Another legislation was passed at the end of 2019 that reverted the child tax rate to that of the parents. Parents who paid the estate tax rate in 2018 and 2019 will change their income tax returns to pay the parent rate instead. “For 2018 and 2019 returns, taxpayers should calculate the kiddie tax using either the estate tax rates or the parents’ tax rate,” Shannonhouse says. “From 2020 onwards, the parent’s tax rate will apply.”
You have three years from the tax-filing deadline to make changes to your return. “When deciding to amend, the parents should compare the outcomes and decide whether the gain is adequate to justify the time and expense,” says Trank. “Amending could save taxes if the parents are in the middle or lower tax brackets.”