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When it comes to taxes, children are typically in lower income tax brackets in the USA. That is why many wealthy parents would shift income-producing assets to their children’s names to avoid paying taxes at their top marginal tax rates, up to 37%.
But the Tax Reform Act of 1986 changed it all. The new act requires a child’s unearned income above a specific threshold to be taxed at the parent’s tax rates. As a result, ‘Kiddie Tax’ was born.
Despite its sweet-sounding moniker, the “kiddie tax” is an often-misunderstood tax provision that can result in sizable income tax liability for your family. So, it is important to understand what kiddie tax is and how to avoid it.
If your child has an unearned income, it is a tax you should be aware of.
Kiddie Tax was introduced to deter wealthy parents from pushing certain incomes into their children’s lower tax rates. This tax provision has seen many revisions. As of 2023 kiddie tax rules, a minor’s unearned income typically includes:
Under the current IRS rules for 2023, the unearned income threshold is $2,500 (up from $2,300 in 2022). The first $1,250 of a child’s unearned income is earned tax-free, and the next $1,250 is taxed at the child’s rate. Anything over $2,500 for 2023 is taxed at the parent’s tax rate instead of the child’s lower tax rate.
The child’s age is the most important factor in determining Kiddie Tax.
The tax rules can be even more complicated if your child also has earned income. For more information, see IRS Publication 929 or consult an experienced tax advisor.
Kiddie Tax for tax year 2023 will be filed in 2024. To calculate the tax amount, you have to first determine the child’s taxable income:
Families with unearned income subject to Kiddie Tax have to file IRS Form 8615 along with their federal tax return. Children with unearned income exceeding $13,850 or any earned income must file a distinct tax return. However, if a child’s unearned income falls below $13,850 but exceeds $1,250, it may be incorporated into their parent’s income tax return.
Let us walk you through an example of calculating Kiddie Tax for a child in 2023:
Suppose a child named Alex is 16 years old at the end of 2023. Alex has unearned income from investments, such as interest and dividends, totaling $3,000 for the year. Also, Alex has no income from a job or any other source.
Since Alex has $3,000 in unearned income, we will calculate the tax on the portion that exceeds $2,500. Unearned income subject to tax = $3,000 – $2,500 (threshold) = $500. There will be tax at Alex’s tax rate on the $500 of unearned income above the threshold.
Since Alex is under 18 years old, and the unearned income is within Kiddie Tax threshold, we will calculate the tax using the child’s rate. Let us assume the child’s tax rate is 10% in this example.
So, Kiddie Tax on the $500 of unearned income = $500 (unearned income) * 0.10 (tax rate) = $50
Being a parent, you might wonder how to avoid Kiddie Tax. Keep reading to know.
Net unearned income calculation depends on whether the child itemizes deductions or not. But it cannot exceed the child’s taxable income.
If the child does not itemize:
Net unearned income = Child’s unearned income for the year – (2 X Limited standard deduction for dependents)
Two times the limited standard deduction for dependents is $2,500 for 2023 and $2,300 for 2022.
If the child itemizes deductions:
Net unearned income = Child’s unearned income for the year – (larger of the following:)
The parents may elect to include on their return the child’s unearned income to avoid the kiddie tax. For the election, parents have to fill the Form 8814.
Making these calculations can be tricky. At GNS-CPAS, our tax experts can make these calculations for you and help with 2023 tax planning.
Fortunately, there are some ways to avoid the potential exposure to Kiddie Tax. However, we do not encourage tax avoidance as the primary reason for tax planning.
Now, let us check out some ways to avoid Kiddie Tax:
Consider investments that generate tax-efficient income, such as growth stocks that don’t pay dividends or tax-exempt municipal bonds. This can help keep your child’s unearned income below the Kiddie Tax threshold.
Similarly, kiddie tax does not include tax-exempt interest. So, choose tax-exempt assets such as bonds, notes, bond funds, leases, mutual funds, life insurance, and trusts.
Capital losses often result in lower unearned income. If the loss brings the unearned income below the annual threshold, Kiddie Tax does not apply.
If your child does not earn income, s/he may qualify for a Roth IRA account. This has many benefits. For the 2022 tax filing year, you can add $6,000 to your child’s Roth IRA, and this contribution reaches $6,500 for 2023.
The contribution amount cannot be greater than the child’s earned income. But this is a great way to transfer thousands of dollars to your child yearly.
The income earned within the Roth IRA is tax-deferred. In addition, the investment income accumulated within the Roth IRA will be tax-free when the account holder reaches age 59 ½ and holds a Roth plan for at least five years. Plus, you can withdraw contributions to a Roth IRA plan at any time without tax consequences.
The 529 plan lets you transfer the largest amount of money to your child while avoiding Kiddie Tax or tax consequences. These plans allow parents and grandparents to fund a child’s education.
There are no income restrictions for contributors! There is no limit on contributions! However, you can limit contributions to the federal gift tax threshold amount to avoid the gift tax.
Investment income in a 529 plan is tax-free. You have no tax obligations on the distribution as long as you use the funds for the child’s qualified education expenses.
Be aware that Kiddie Tax rules consider both unearned and earned income. If your child has a part-time job, ensure their earned income remains below the thresholds.
At GNS CPAS, we believe that you deserve a smooth, hassle-free, and stress-free tax treatment. Over the years, we have helped many parents like you who need to report their children’s earned and unearned income.
Schedule a call with our tax experts and see how we can help you.
We will happily offer you a free consultation to determine how we can best serve you.
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