Establishing investment accounts for your children is a great way to plan for their future. If this is something you have considered, you should be aware of how the Kiddie Tax works.
When a child has unearned or investment income in excess of $1,900, the Kiddie Tax kicks into effect. The first $950 of income is tax free; the second $950 is taxed at the child’s tax rate, typically 10%. Above $1,900, the income is subject to the parents’ marginal income tax rate.
Here is an example. John is 16 years old, has investment income of $2,500 and no earned income. His parents’ marginal tax bracket is 28%. He would pay taxes as follows:
The first $950 of income: no tax
The second $950 is taxed at 10%: $95
The remaining $600 is taxed at John’s parents’ tax rate of 28%: $168
John’s effective tax rate would be 10.52%. By filing his own tax return, less taxes will be due than if his income is included on his parents’ tax return, considering that they are in a 28% marginal tax bracket.
Kiddie Tax rules apply until the year in which the child turns 18, unless he or she earns more than half of his or her overall support. The rule still applies if a child age 19 to 23 is a full time student for at least 5 months of the year.
The tax calculation becomes more complicated if your child had earned income in addition to investment income. For more information, please refer to IRS Publication 929. We would also suggest discussing this subject with your accountant.