09 Jun 2022 Kiddie Tax 101
If you’re on any form of social media, you most likely saw pictures and videos circulating from last weekend’s Platinum Jubilee celebrations for Queen Elizabeth. My favorite image of the bunch is of 4-year old Prince Louis making faces at his mom, the beautiful Kate Middleton, as she attempts to be stern, keep him under some semblance of control, and remain composed herself. (If you missed it, see the second to last picture in this article). I think parents around the world collectively sighed with relief that their toddler parenting experiences aren’t that different from a royal family’s experience – at least, from a toddler behavior perspective! In honor of the laughter that Prince Louis provided to his worldwide fans, I thought I’d focus on one element of planning around kids for this week’s brief – the kiddie tax. This subject isn’t nearly as fun as toddlers at the Jubilee, but I’ll do my best to keep this short and sweet.
The basic premise behind the “kiddie tax” is to prevent parents from shifting too many assets into their child’s name, subsequently moving all the associated income from that asset into the child’s lower tax rate. Rules changed around 1987, and now we have the kiddie tax. A child’s income is classified as either unearned income or earned income. If the unearned income exceeds a certain dollar amount, the tax rate assessed on the excess reverts back to the parents’ tax rate, instead of the child’s tax rate.
Children under 19 years (at the end of a tax year) or under 24 years (if a full-time student) may have kiddie tax applied to them, depending on how much income is received, and whether that is unearned or earned income, or a combination of both. A dependent with unearned income has a limited standard deduction of $1,150 (for 2022) to use against that unearned income (interest, dividends, etc.). Kiddie tax rules mean that the standard deduction covers the first $1,150 of unearned income, the next $1,150 is taxed to the child at the child’s rate, then any net unearned income over $2,300 is taxed to the child at the parents’ marginal income tax rate. If earned income (from summer job wages, salaries, etc.) enters the picture, the child’s standard deduction is either the greater of $1,150 OR the amount of earned income plus $400, not to exceed the full individual standard deduction amount of $12,950 (for 2022). The IRS is fine with a child working to earn income and receiving the full standard deduction. But the IRS does want to capture the unearned income that in their view, the child wouldn’t have if it weren’t for their parents, so therefore should be taxed at the parents’ rate.
A UTMA or UGMA custodial account is an example of something that could generate unearned income in a child’s name. By contrast, a 529 account for the benefit of the child, does not generate this unearned income.
Here’s a high level example to show you how this works:
Parents, who are in the 32% marginal tax bracket, gave $15k to their child several years ago and invested the funds in a UTMA custodial account for the child. Now, the child is 16, and the account value has increased to $25,000. The investments somehow generate $2,500 in dividend income.
$2,500 (unearned income)
-$1,150 (limited standard deduction)
-$1,150 (taxed at child’s rate of 10%)
$200 (taxed at parents’ rate of 32%)
So, estimated taxes owed are $115 (from the child’s tax rate) + $64 (taxed at the parents’ rate), to total $179 total tax owed on the $2500 of dividends, which is an effective tax rate of 7%. If the parents had invested the $15k in their brokerage account, the taxes owed on the $2,500 dividend income would be roughly $800.
This is obviously a very basic example to give you an idea of how much tax may be calculated at a parent’s marginal tax rate if the kiddie tax applies. You most likely won’t need to do these calculations yourself. To keep this simple, I’m also not getting into whether these were qualified dividends/capital gains, etc. When investing a custodial account, it’s important to pay attention to the account balance, the parents’ tax rate, investment type, and management style, as those factors really impact how much kiddie tax rules come into play. For example, investing in an exchange traded fund may be more tax efficient than a mutual fund with capital gains payouts.
Taxation on a child’s earned income is more straightforward. Schools are wrapping up (or already finished for the year) this week and many high school and college students are about to start summer jobs. As I mentioned earlier, the standard deduction for the dependent with earned income, or a combination or unearned and earned income, is the greater of $1,150 or the amount of earned income plus $400, not to exceed $12,950 (for 2022). This means that a 16-year-old could earn as much as $12,950 in earned income and not be subject to any federal income tax! (FICA taxes may still apply.) As a side note, sometimes the child will have to have taxes withheld but then receive a refund after filing a return the next year.
It’s a little more complex if there is a combination of earned and unearned income, and I won’t bore you with more math here. The calculation is slightly different but it’s still just the portion of unearned income that might be taxed back at the parents’ rate. With the increase of popularity in trading apps like Robinhood, some families may have surprises at tax time if your dependent child was successful with investing in a taxable brokerage account. There may be other more tax efficient ways for your child to invest that would not be impacted by the kiddie tax. For example, if the child does have earned income, they’re eligible to contribute to a Traditional or Roth IRA. As with any investments, there’s potential to lose the principal, but gains won’t be subject to the kiddie tax rules.
All this to say, don’t worry about a child’s summer job but do exercise some caution if opening a brokerage account for your kid – at least just to understand what you and your child might be getting into from a tax perspective! You may need to consult your CPA to make sure that your child files a return if they need to, and that any income or capital gains are reported appropriately. Gifting strategies, investment income, and taxes can be confusing, and we’re here to help you navigate through these things so you can get back to the things that matter most in your life.
The content above is for informational and educational purposes only. The links and graphs are being provided as a convenience; they do not constitute an endorsement or an approval by Beacon Wealthcare, nor does Beacon guarantee the accuracy of the information.
This is not tax advice. Please consult your tax professional.