Federal Income Tax: Kiddie Tax
Students: The CFP requires you to be able to understand and calculate “Kiddie tax” liability. Make sure you understand how the different standard deductions work!
Individuals: This might be relevant if your kid works, has a custodian investment account (UTMA/UGMA, trust account), or receives any other unearned income. If you have a family business - make sure to read the bottom section!
Advisors/Professionals: Important to understand how kiddie tax is different and can be worse OR better for a family’s overall tax liability depending on how it is utilized.
Kiddie Tax - The Basics
Why are there special “kiddie tax” rules? The Government/IRS doesn’t want rich/high-income families shoving investments into their kids hands so they can pay lower tax rates than their parents.
Basics of the rule: Kids (dependents) with income (unearned and/or earned) are taxed on their income but also get a standard deduction (calculated different though). For kids with high unearned income they will be taxed over a certain amount at their PARENT’S HIGHEST MARGINAL TAX BRACKET (instead of their own - which would be much lower). (This rule has changed. A few years back it applied this “excess amount” to the “trusts and estates tax brackets”)
Who is a “kiddie” under these rules?? A dependent child under the age of 19 or ages 19-23 if a full-time student and claimed as a dependant on their parent(s) tax return.
Intuit Article on Kiddie tax rules (for 2020)
IRS Publication 929 on child taxation
First lets go over basic standard deduction rules (for dependent children).
Child with taxable income can claim the larger of $1,100 or “earned income + $350” (to a maximum of the current year standard deduction = in 2021 that is $12,550)
Example 1: Child has $500 of earned income and $50 in bank CD interest. $500 (EI) + $350 = $900. They’d claim the larger $1,100 standard deduction!
Example 2: Child as $1,500 in unearned income (dividends/capital gain). They’d claim the $1,100 standard deduction (no earned income to add)
Example 3: Child has $4,000 of earned income and $1,000 unearned income. $4,000 (EI) + $350 = $4,350 standard deduction.
Example 4: Child as $13,000 of earned income and $100 of unearned income. Max standard deduction for an individual is $12,550 (2021 amount).
Now what? Well there are three scenarios: Child with only earned income, child with only UNearned income, child with both earned and unearned income.
If the child has ONLY earned income then it is very simple! If they are under the standard deduction = no federal tax. If they are over = it is calculated at their own tax rates.
Example: Child has $15,000 in earned income.
First $12,550 (2021 standard deduction) isn’t taxed. (or we’d say “reduce their income by this amount”)
Remaining taxable income is now $2,450 which would be taxed at the first bracket (10% rate).
If the child has only UNearned income then you use the following “kiddie tax” formula.
First $1,100 is not taxed (covered under the standard deduction)
Next $1,100 is taxed at the child’s tax rate (first tax bracket starts at 10% which is also 0% for capital gain/qualified dividends - see bottom for planning tip)
Unearned income over $2,200 is taxed at the PARENT’S highest marginal tax rate. (so while the kid would start at the 10% bracket, the parent might be in the 24% bracket)
Example 1: Child has $2,000 of unearned income (lets assume taxable interest from CDs)
First $1,100 isn’t taxed (“reduced by standard deduction”)
Remaining $900 would be taxed a the child’s tax rate of 10%
Example 2: Child has $4,000 of unearned income (again, lets assume taxable interest from CDs)
First $1,100 isn’t taxed
Next $1,100 is taxed at child’s tax rate (10% = first bracket)
Remaining $1,800 ($4,000- $2,200) is taxed at the PARENT’S marginal tax rate (let’s assume they are in the 24% bracket)
What if the child has both earned and unearned income? Then it is more complicated!
You must calculate taxable income while also deciphering how much is earned income (and applies under the standard deduction) and how much is unearned income and applies under the kiddie tax thresholds.
You’ll calculate the unearned income separately against the $2,200 ($1,100 standard deduction + $1,100 taxed at child’s rate) to find the net amount taxable at the parent’s tax rate. It is easier to show through examples…
Example 1: Child has earned income of $5,000 and unearned income of $3,000. (assume CD interest)
First - what standard deduction do we use? ($1,100, EI+$350, or $12,550?) Earned income + $350 (so $5,350!).
But wait - should any of the unearned income be taxable at the parent’s rate? Maybe? (Yes!)
Calculate separately: $3,000 - $2,200 = $800 of unearned income that should be taxed at the parent’s rate.
Put it all together:
$8,000 of income
Less $5,350 deduction
Leaves $2,650 taxable
$800 is taxed at that parent’s tax rate (calculated separately)
Remaining $1,650 is taxed at the child’s tax rate.
Example 2: Child has $500 of earned income and unearned income of $5,000. (assume CD interest)
Standard deduction? In this case = $1,100 (since EI+$350 is less than $1,100)
What should the “kiddie tax” apply to? (at parent’s rate)
Calculate separately: $5,000 - $2,200 = $2,800 of unearned income that should be taxed at the parent’s rate.
Put it all together:
$5,500 of income
Less $1,100 deduction
Leaves $4,400 taxable
$2,800 is taxed at that parent’s tax rate (calculated separately)
Remaining $1,600 is taxed at the child’s tax rate.
What “planning opportunities” are there within the confines of the kiddie tax dilemma?
Family Business - if you can legitimately employee your children through your family business they will be receiving income (earned) and have their own large standard deduction ($12,550 in 2021) to offset/reduce their income by! In addition, family businesses don’t pay payroll tax on their children when under age 18/21 (wow!!).
The income must be “reasonable and necessary” (you can’t pay your kid $60k/yr for part time filing work) But you could certainly pay your child on the “higher end of reasonable…”
If you can pass some of your busy work off to them you are effectively transferring work/income from your tax bracket to them! (Let’s be honest - you were going to give them $$ to go out with their friends anyways)
ADDED BONUS: The child with earned income (from anywhere) can start/fund a Roth IRA!! (or other retirement account depending on age/minimum requirements)
Capital gains/dividends - Remember that long term capital gains and qualified dividends in the first two tax brackets (10%, 12%) are actually taxed at a federal rate of 0% (yes ZERO!). So by having your child have SOME unearned income that is capital gains/dividends (as in the first $1,100 that is taxed at their rate), they can effectively pay a 0% long term capital gain rate.
For a wealthy family passing big $$$ on to a kid - this likely doesn’t apply.
For a family with a child with an investment account or UTMA/UGMA account - the planning opportunity would be to consider selling from time to time to intentionally “raise your cost basis” without paying much/any tax.
Example - 5yo child has 30k left by grandparent in an UTMA account that is invested in an aggressive mutual fund. By the time they are 25, the fund might be worth $120,000 (assuming a rough 7% rate of return). If the young adult now cashed it in to pay for a car/wedding/down-payment on a house they’d be shoved into a much higher tax bracket that year with the large realized capital gain!
Alternative - every year generate approximately $2,200 in realized gain (between qualified dividends and partial sells). Over time you’d be able to step up your cost basis and have less capital gain to realize as an adult (when you’d like liquidate/use the funds). Additional good idea would be to spread out gain (as an adult, after college/FAFSA) over a 2-5ish years if you fall in the 2nd tax bracket those next few years (likley) you could slowly chip away at the LTCG (long term capital gain) with some still being in the 0% capital gain bracket (the first two income brackets).