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This article was fact-checked by our editors and Jennifer Samuel, senior product specialist for Credit Karma Tax®. It has been updated for the 2020 tax year.
Think you can minimize your income tax bill by shifting investments to your children’s names?
The kiddie tax may put a wrinkle in your plans.
It’s natural for taxpayers to want to minimize taxes and keep more of their hard-earned money. For a time, some wealthy taxpayers with children were able to accomplish this by shifting their assets to their children, who were in a lower tax bracket.
The kiddie tax put an end to this tax-avoidance strategy. But the tax doesn’t just affect the wealthy. The kiddie tax could impact any child with investments in their name.
- What is the kiddie tax?
- Who has to pay the kiddie tax?
- When the kiddie tax kicks in
- How much is the kiddie tax?
- How can you avoid paying the kiddie tax?
What is the kiddie tax?
Congress established the kiddie tax more than 30 years ago as part of the Tax Reform Act of 1986.
Before the act, parents with significant investment income could reduce their tax bill by placing investments in the names of their children. The children would have less total income than their wealthier parents and, therefore, be taxed at a much lower rate.
To help close that loophole, the 1986 tax reform act stated that certain types of unearned income of children younger than 14 — such as investment income — would be taxed as if the money was the income of the parent. Under the so-called “kiddie tax,” depending on the type and amount of the unearned income, a portion of the investment earnings held in the child’s name was tax-free, a portion was taxed at the child’s marginal tax rate, and any amount over a given threshold was taxed at the parent’s marginal rate.
While there have been other changes to the kiddie tax over the years, the Tax Cuts and Jobs Act of 2017 changed the rules for applying the kiddie tax. Under the TCJA, a child’s investment income wasn’t taxed at the parent’s marginal tax rate. Instead, it’s taxed at the rates applicable to trusts and estates if the child’s interest, dividends and other unearned income totals more than $2,200. But in 2019, Congress changed kiddie tax rules again, reverting back to pre-TCJA rules.
Who has to pay the kiddie tax?
Like much of the tax code, the kiddie tax has become more complicated over time. For example, the original version applied to children younger than 14.
Today’s rules are a lot more complicated. The kiddie tax applies to certain children younger than 18 and certain older children that meet additional qualifying requirements.
Unearned income only
One thing about the kiddie tax that hasn’t changed is the type of income it affects. The tax only applies to unearned income, which can include any of the following:
- Ordinary dividends
- Taxable interest
- Capital gains
- Income from rents and royalties
- Social Security benefits
- Pension or annuity income
- Taxable scholarships or fellowship grants (if not reported on your Form W-2)
- Unemployment compensation
- Income received as the beneficiary of a trust
If your child has an after-school job, those wages are likely considered earned income and aren’t subject to the higher tax rate.
Children who have unearned income that’s subject to the kiddie tax must file a Form 8615 with their 1040 tax return.
When the kiddie tax kicks in
Your child may be required to file a tax return to report and pay tax on income they earned, but without being subject to the kiddie tax. Generally, the kiddie tax kicks in when a child meets all of the following:
- Is required to file a tax return
- Has more than $2,200 of unearned income
- Was younger than 18 or was 18 and didn’t have earned income that was more than half their support at the end of the tax year
- Had at least one living parent at the end of the tax year
- Didn’t file a joint return for the year
If your children meet all of these filing requirements, they must pay taxes on their unearned income. But they don’t necessarily need to file their own tax returns.
The tax law allows parents of children younger than 19 (or younger than 24 and a full-time student) with income between $1,050 and $10,500 consisting only of interest and dividends, including capital gains distributions, to elect to include the child’s income on their return. The income is reported on Form 8814.
How much is the kiddie tax?
For 2020 and later tax years, children’s unearned income is taxed at their parent’s marginal tax rate. In 2019, Congress reversed changes the Tax Cuts and Jobs Act of 2017 had made to the kiddie tax.
Under the TCJA, tax on a child’s unearned income was calculated using the ordinary and capital gains tax rates for trusts and estates.
And, there’s a potential complication for filers who have to pay the kiddie tax. They may also be subject to the lesser of the net investment income tax —or any modified gross income that exceeds the set threshold amount.
What is the NIIT?
If you have investment income, you may find you’re subject to the net investment income tax, or NIIT. This can happen if you have a one-time increase in your investment income, say from selling inherited stock or an investment property.
NIIT applies to investment income earned from from annuities, interest, dividends, capital gains, income from passive activities, rents and royalties. If your modified adjusted gross income exceeds a certain amount for your filing status, you may have to pay the NIIT.
How can you avoid paying the kiddie tax?
The easiest way to avoid the kiddie tax is to keep your child’s annual investment income at $2,100 or less. You can accomplish this by investing in things that appreciate in value over time but don’t generate current income.
Another option is saving inside a 529 plan. Investments are allowed to grow tax-free in a 529 plan and withdrawals are tax-free as long as they are used for qualified education expenses for the beneficiary, like tuition, room and board. Thus, neither investment earnings nor qualified withdrawals from a 529 plan will trigger the kiddie tax.
It’s not uncommon for parents and grandparents to make financial gifts to children and young adults. However, before you transfer income-producing or highly appreciated assets, be sure to consider the kiddie tax. Failing to do so can inadvertently increase your family’s taxes and affect you in ways you weren’t expecting. Get advice from a tax professional or financial adviser to make sure the kiddie tax doesn’t come as an unwelcome surprise.
Jennifer Samuel, senior tax product specialist for Credit Karma Tax®, has more than a decade of experience in the tax preparation industry, including work as a tax analyst and tax preparation professional. She holds a bachelor’s degree in accounting from Saint Leo University. You can find her on LinkedIn.