Kiddie Tax: Tax on a Child's Investment Income

The so-called Kiddie Tax is intended to prevent parents from reducing their tax burden by shifting ownership of income-producing assets to their children. The tax benefit from shifting assets is significantly reduced by requiring unearned income above a specified threshold to be taxed at the parent’s rate. Nevertheless, unearned income below that threshold is taxed at a more favorable rate. However, child assets are assessed more severely than parent assets by financial aid formulas, making the Kiddie Tax a viable way of saving for college only for families who will not qualify for need-based student financial aid.

Kiddie Tax

Unearned income by a dependent up to the standard deduction for a dependent is tax-free. This threshold is $950 in 2012, $1,000 in 2013, $1,000 in 2014 and $1,050 in 2015.

If the child’s earned income is less than or equal to half of his or her support, the next increment of income up to twice the standard deduction for a dependent ($1,900 in 2012, $2,000 in 2013, $2,000 in 2014 and $2,100 in 2015) is taxed at the child’s rate. If the child is under age 19 (24 for full-time students) as of December 31 of the calendar year in which the taxpayer’s tax year begins, any remaining income is taxed at the parent’s rate. If the child is age 19 or older (24 for full-time students) as of December 31 of the calendar year in which the taxpayer’s tax year begins, any remaining income is taxed at the child’s rate.

If the child’s earned income exceeds half of their support, the next increment of income up to twice the standard deduction for a dependent is taxed at the child’s rate. If the child is under age 18 as of the end of the tax year, any remaining income is taxed at the parent's rate. If the child is age 18 or older as of the end of the tax year, any remaining income is taxed at the child's rate.

The taxes are assessed on all income, including both earned and unearned income. Unearned income includes investment income, such as interest, dividends and capital gains.

Children usually pay taxes in a lower tax bracket due to their lower income. If the parent owns a company, the parent can pay the child a portion of the company’s revenues to the child and have it taxed at the child’s rate, if the child's age is over a particular threshold. This age threshold was previously age 14, but Congress increased it to 18 and later to 19 (24 for students) to reduce the value of splitting income via the Kiddie Tax.

Financial Aid Impact

Child assets are assessed more harshly than parent assets by need analysis formulas. For example, the federal need analysis methodology counts 20% of child assets as part of the expected family contribution, a much higher percentage than parent assets. A portion of the net value of parent assets are sheltered by an asset protection allowance and the remaining reportable assets are assessed on a bracketed scale that tops out at 5.64%.

Accordingly, taking advantage of the Kiddie Tax by saving in a child’s name may significantly reduce or eliminate the child’s eligibility for need-based financial aid. There are, however, a few workarounds.

  • The parent can move the assets of a minor child into a custodial 529 college savings plan. The child is the account owner and beneficiary of a custodial 529 plan, but a custodial 529 plan is treated as though it were a parent asset on the Free Application for Federal Student Aid (FAFSA) if the child is a dependent student.
  • The parent can spend the child's assets for the child's benefit on non-parental obligations. For example, if the child needs a car or computer for school, the parent can use the child's money to purchase it.
  • The parent can spend down the child's assets to pay for college costs before touching the parent's assets. This prevents the child's assets from affecting aid eligibility in subsequent years.

Coordination Restrictions

The kiddie tax is not subject to any coordination restrictions.

Eligibility

The eligibility rules are complicated, with some age thresholds measured relative to the tax year and other age thresholds measured relative to the calendar year in which the tax year begins. For example, a child is subject to the Kiddie Tax rules if the child will not have reached age 18 before the end of the tax year or, if the child is age 18 or older and the child’s earned income does not exceed half of the child’s support for the tax year, the child will not have reached age 19 (age 24 if a student) before the end of the calendar year in which the tax year begins. For example, a 17-year-old student is always subject to the Kiddie Tax rules while an 18-year-old student might not if the student has enough income.

The Kiddie Tax rules also specify that the child must be required to file an income tax return for the year, at least one parent must still be alive at the end of the tax year and the child must not file a joint return for the tax year.

Income Phaseouts

There are no parent income phaseouts on eligibility for the Kiddie Tax. Rather, there are income thresholds on the applicable tax rates for child income between the standard deduction for a dependent and twice the standard deduction and child income above twice the standard deduction for a dependent.

Expiration

The legislation implementing the Kiddie Tax does not expire.

References

IRS Publications

Forms

Current Law

Legislative History

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