All parents should become familiar with the “kiddie tax,” as it can negatively affect a family’s overall income tax liability.
The “kiddie tax” applies to the amount of net unearned income of a child under the age of 18, and that of 18-year-old children or 19- to 23-year-old students who do not provide half of their own support with earned income. The net unearned income is generally taxed at the parents’ highest marginal tax rate.
Net unearned income is defined as adjusted gross income for the year less any amount attributable to earned income. The result is then reduced by the standard deduction amount, which could vary based on a couple of factors to be discussed later.
This amount is further reduced by the greater of $1,050 (for 2015), or if the child itemizes deductions, the amount of allowable itemized deductions directly connected to the production of the child’s unearned income.
Earned income is compensation received in exchange for services. W-2 wages and Form 1099 self-employment income are the two main examples.
The standard deduction amount in 2015 for a single person who can be claimed as a dependent on someone else’s return and has no earned income is $1,050. This amount changes when the single person has earned income. The sum of the single person’s earned income plus $350, up to the standard deduction amount of $6,300, would be the standard deduction amount for someone with earned income.
However, most children do not itemize deductions because they usually don’t own their own home or donate money to charity. For most situations, the additional $1,050 deduction would be taken.
This means that a dependent child can have up to $2,100 in unearned income without triggering the kiddie tax.
A planning technique used by parents or grandparents is to gift a child some money and open up a brokerage account. The child then buys stocks, bonds or other investments in the brokerage account and starts earning a return on their money. This interest and dividend income is then taxed at the child’s lower tax rate.
This is where the savings come into play. Normally, that money would remain in the parent’s or grandparent’s brokerage account and be subject to income tax at the parent’s or grandparent’s much higher tax rate.
The trick is to keep the earnings below the $2,100 amount so that the kiddie tax is not triggered and the child and family get the benefit of the lower tax rates.