Understanding \"Kiddie Tax\"

July 7th, 2023 at 3:10 PM

I wanted to take this opportunity to touch base regarding the federal income tax rules on the “kiddie tax” and its potential impact on your financial strategy for your child(ren).

In brief, the kiddie tax was enacted by Congress to prevent parents from passing investment income to their children, who typically have a lower tax rate. Under the kiddie tax rules, a portion of a child’s net unearned income may be taxed at the parent’s marginal federal income tax rate. The kiddie tax applies to children up to age 24, assuming they meet certain criteria.

The kiddie tax can result in higher taxes on an affected child’s net unearned income than otherwise would apply. For example, if a child’s net unearned income exceeds the annual threshold of $2,500 for 2023 (increased from $2,300 in 2022), the portion of the income exceeding the threshold is subject to the kiddie tax.

The kiddie tax does not apply if the child’s net unearned income for the year does not exceed the threshold for that year.

There are four primary criteria for the application of the kiddie tax, including the child not filing a joint return for the year, at least one parent being alive at year’s end, the child’s net unearned income for the year exceeding the threshold for that year, and the child falling under specific age rules.

Despite these rules, there are several strategies to limit the kiddie tax’s impact on your child’s unearned income:

Exploit the unearned income threshold. Manage your child’s unearned income to ensure it remains below the annual threshold.

Pick the right investments. You can reduce unearned income by selecting investments with minimal or no dividends, such as growth stocks or tax-efficient mutual funds.

Invest in Series EE U.S. Savings Bonds. The accumulated interest income from these bonds is tax-deferred until cashed in, meaning no kiddie tax applies if cashed in when the child is kiddie-tax-exempt.

Use a Section 529 College Savings Plan. Withdrawals from a Section 529 plan account are federal-income-tax-free, provided they’re used for qualifying education expenses.

Invest in life insurance products. Investment accounts included in life insurance products such as universal life policies allow tax-deferred accumulations and can be borrowed against for college costs.

Generate earned income. The kiddie tax does not apply to children aged 18-23 if their earned income exceeds 50 percent of their support for the year.

Mark S. Fineberg, CPA