The Tax for Certain Children Who Have Unearned Income, informally known as the “Kiddie Tax,” can sneak up on unsuspecting taxpayers. This section of the Tax Code was initially created to prevent taxpayers from reducing their tax bill by shifting some of their unearned income — such as interest, dividends, and capital gains — into the lower tax brackets of their children. The Tax Cuts and Jobs Act of 2017 (TCJA) did not completely overhaul the Kiddie Tax, but it did change it in one significant way. Before we discuss the change and its implications, let’s go over the Kiddie Tax basics.
Kiddie Tax Basics
Children who were under the age of 18 at the end of the year who report unearned income above $2,100 currently will be subject to the Kiddie Tax. Older children may also be subject to the Kiddie Tax, including:
- 18-year-olds whose earned income (like wages from a job) did not exceed half the cost of their annual support.
- Individuals who are age 19 to 23, if (1) they are full-time students, and (2) their earned income does not exceed half the cost of their annual support.
The tax itself will be reported on the child’s return, not the parents’. Prior to tax year 2018, unearned income above this $2,100 threshold was taxed at the parents’ highest marginal tax rate. The TCJA changed this rule for tax years 2018 through 2025. The major change to kiddie tax is that a minor’s unearned income above the $2,100 may be taxed using the tax rates for trusts and estates rather than his/her parents’ top marginal tax rate.
Implications of the Change
At first glance, the highly compressed tax brackets for trusts and estates seem disadvantageous for all minor taxpayers. Compared to individual tax brackets, the trust and estate tax rates accelerate much more quickly, as seen in the bracket-by-bracket comparison.
|2018 Ordinary Income Tax Rates
These rates apply to interest, nonqualified dividends, and short-term capital gains.
|Individual — Married Filing Jointly||Trusts & Estates|
|10%||$0 to $19,050||10%||$0 to $2,550|
|12%||$19,051 to $77,400|
|22%||$77,401 to $165,000|
|24%||$165,001 to $315,000||24%||$2,551 to $9,150|
|32%||$315,001 to $400,000|
|35%||$400,001 to $600,000||35%||$9,151 to $12,500|
|37%||$600,001 +||37%||$12,501 +|
However, some taxpayers could be better off under the new law. Why? The reason is that the Kiddie Tax is calculated using the progressive rates of trusts and estates rather than a single marginal tax rate.
With a progressive tax rate, not all income is taxed the same. The first $2,550 of Kiddie-taxable income will be taxed at 10%; the next $6,600 will be taxed at 24%; and so on. Under the old rules, the parents’ marginal tax rate was applied as a flat tax across the board.
Let’s look at an example below where the new Kiddie tax change works for the better:
John and Joan, who file a joint return, had taxable income of $450,000 in 2018, which places them in the 35% tax bracket. Their daughter, Janie, reported $14,000 of interest and dividends from a brokerage account set up in her name to help save for college. If the TCJA had not altered the Kiddie Tax rules, Janie would owe $4,165 in Kiddie Tax.
$14,000 – $2,100 = $11,900 tax base
$11,900 × 35% = $4,165 Kiddie Tax
However, the new rules state that Janie must calculate her Kiddie Tax using the trust and estate progressive tax rates. Under this system, she would only owe a Kiddie Tax of $2,802.
$14,000 – $2,100 = $11,900 tax base
$11,900 × progressive rates (see calculation below) = $2,802 Kiddie Tax
|Trust & Estate Tax Brackets||Progressive Tax Calculation|
|10%||$0 to $2,550||$2,550||×||10%||=||$255|
|24%||$2,551 to $9,150||$6,600||×||24%||=||$1,584|
|35%||$9,151 to $12,500||$2,750||×||35%||=||$963|
Using a progressive rate will not always leave taxpayers better off than a flat marginal rate, but the example above shows that some taxpayers may find the new law beneficial.
Planning for 2019
A few steps parents should take in 2019 to control Kiddie Tax:
- Monitor your children’s unearned income.
- A tax professional can help you calculate what a “safe” amount of unearned income would be for each of your children.
- Review the class of income being earned by your children.
- Ordinary income is taxed differently than capital gains. There may be room for tax-saving strategies that shift income from one class to another.
- Consider alternative investment vehicles for your children.
- Brokerage accounts may or may not be the best way to help your children save money. Have you considered a 529 plan? What about a life insurance policy or a custodial account? Not all investment gains are subject to the Kiddie Tax.
- Look into hiring your children.
- It may be an effective strategy to hire your kids to work in the family business. Earned income is not subject to the Kiddie Tax.
To discuss these strategies or learn how the Kiddie Tax will impact your 2018 and 2019 returns, contact your CRI tax advisor.