Kiddie Tax: How It Works, Examples, and Tax-Saving Strategies
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Summary:
The kiddie tax is a tax law designed to prevent parents from transferring large gifts of stock to their children to exploit lower tax rates. Unearned income over a threshold is taxed at the parent’s rate rather than the child’s. This law applies to individuals under 18 or dependent full-time students aged 19-24. This article delves into the history, details, and implications of the kiddie tax.
Kiddie tax: A closer look
The kiddie tax is a significant aspect of the U.S. tax code, designed to address investment and unearned income taxation for certain individuals. This article explores the intricacies of the kiddie tax, its history, how it works, and who it applies to.
Understanding the kiddie tax
The kiddie tax is a tax provision enacted in 1986 to tackle a specific tax avoidance strategy. It was introduced to prevent parents from avoiding taxes by gifting large amounts of stock or investments to their children. By doing this, the children could realize gains from these investments and be taxed at a much lower rate compared to their parents, who typically face higher tax rates on their gains.
Under the kiddie tax law, unearned income exceeding a predetermined threshold is taxed at the parent’s marginal income tax rate instead of the child’s tax rate. This provision aims to close the tax loophole that allowed parents to take advantage of their children’s lower tax rates.
For example, in 2022, unearned income under $1,150 qualifies for the standard deduction under kiddie tax law. The next $1,150 is taxed at the child’s tax rate, which is usually very low, sometimes even as low as 0%. Any income over $2,200 is taxed at the parent’s tax rate, which can be as high as 37%.
Who the kiddie tax applies to
As of 2021, the kiddie tax applies to all children aged 18 and under at the end of the tax year and to dependent full-time students aged 19 to 24. It’s important to note that the kiddie tax doesn’t apply to children under these age groups who are married and file joint tax returns. The kiddie tax covers unearned income received by a child, such as interest, dividends, capital gains, rent, and royalties. However, any salary or wages the child earns are not subject to the kiddie tax.
Additionally, adult children who turn 19 or 25 in the case of dependent full-time students by the end of the tax year are not subject to the kiddie tax.
History of the kiddie tax
The kiddie tax’s history reveals its evolution and amendments to prevent tax avoidance. Originally, this tax law only covered children under the age of 14 since they legally couldn’t work, and their income primarily came from dividends or bond interest. However, the authorities noticed that some parents would take advantage of the situation and then give stock gifts to their older, 16-to-18-year-old children.
The tax rates for the kiddie tax have seen changes over the years. The Tax Cuts and Jobs Act of 2017 temporarily changed the kiddie tax to use the tax rates that apply to estates and trusts rather than the tax rate of the child’s parents. However, the Further Consolidated Appropriations Act of 2020 retroactively changed it back to the parent’s tax rate. For 2018 and 2019 returns, taxpayers could use either the estate tax rates or the parent’s tax rate for calculating the kiddie tax. However, from 2020 and onwards, the parent’s tax rate applies.
How to handle the kiddie tax
Dealing with the kiddie tax requires careful consideration, especially for parents and guardians looking to gift assets to their children. Understanding the thresholds, rates, and exemptions can help individuals navigate this tax provision while ensuring compliance with the law.
Thresholds and rates
The kiddie tax is triggered when a child’s unearned income exceeds the threshold. In 2022, the threshold for unearned income qualifying for the standard deduction is $1,150. Unearned income between $1,150 and $2,200 is subject to the child’s tax rate, which is often quite low. Any income exceeding $2,200 is taxed at the parent’s tax rate, which can be significantly higher.
Exemptions and planning
It’s important for parents to consider the age of their children and whether they are full-time students. The kiddie tax applies to children aged 18 and under or dependent full-time students aged 19 to 24. It doesn’t apply to children below these age groups who are married and file joint tax returns. This information is crucial for tax planning and determining potential liabilities.
Examples of kiddie tax in action
Understanding how the kiddie tax works can be easier when we examine real-life scenarios. Here are a couple of examples:
Example 1: Gifting stock to minors
Imagine a parent who gifts their 16-year-old child $10,000 worth of stock in a company. Over the next few years, the stock appreciates significantly, and the child decides to sell it when they’re 18. At this point, the value of the stock has grown to $20,000. Under the kiddie tax, the child would be subject to taxation at their parent’s tax rate for the gains realized, which could be significantly higher than if they were taxed at their own lower rate.
Example 2: College savings and the kiddie tax
Parents often set up college savings accounts or custodial accounts for their children. Suppose a 19-year-old full-time college student receives $1,500 in interest income from their custodial savings account and $1,500 in dividend income. Since they’re within the age range covered by the kiddie tax and their unearned income is $3,000, any amount above $2,200 would be taxed at the parent’s rate, potentially leading to higher taxes on that income.
Strategies to minimize kiddie tax
While the kiddie tax aims to prevent tax avoidance, there are strategies parents can employ to minimize its impact:
Use tax-efficient investments
Investing in tax-efficient assets, such as tax-exempt municipal bonds, can help reduce the impact of the kiddie tax. Interest income from these bonds is generally tax-free, making it an attractive option for children subject to the kiddie tax.
Gift wisely
Instead of gifting stocks that may appreciate significantly, parents can consider gifting assets that generate lower income or capital gains, reducing the potential tax liability. This might include assets like real estate or assets with lower growth potential.
Consider tax-efficient accounts
Parents can also explore tax-advantaged accounts like 529 college savings plans, which allow tax-free withdrawals for qualified education expenses. This can be an effective way to save for a child’s education without triggering the kiddie tax.
Conclusion
The kiddie tax is a vital tax provision designed to prevent tax avoidance by parents gifting substantial assets to their children. Understanding its history, thresholds, and how it works is essential for both parents and children. Proper tax planning can help families navigate this aspect of the tax code while remaining in compliance with the law.
Frequently asked questions
What is considered unearned income under the kiddie tax?
Unearned income under the kiddie tax includes interest, dividends, capital gains, rent, and royalties. These are the types of income that are subject to the kiddie tax, while any salary or wages earned by the child are not included.
What is the threshold for unearned income under the kiddie tax in 2022?
In 2022, unearned income under $1,150 qualifies for the standard deduction under the kiddie tax. The next $1,150 is taxed at the child’s tax rate, and any income over $2,200 is taxed at the parent’s tax rate. These thresholds can vary from year to year, so it’s important to stay updated on the latest figures.
Do the kiddie tax rules change if the child is a full-time student?
Yes, the kiddie tax rules take into account the status of the child as a full-time student. It applies to dependent full-time students aged 19 to 24, in addition to children aged 18 and under. However, adult children who turn 19 (or 25 in the case of dependent full-time students) by the end of the tax year are not subject to the kiddie tax.
What is the history of the kiddie tax and its legislative changes?
The history of the kiddie tax is marked by legislative changes aimed at preventing tax avoidance. Originally, it only covered children under the age of 14 who could not legally work. Over time, the law has been amended to include older children. The Tax Cuts and Jobs Act of 2017 temporarily changed the kiddie tax rate, but the Further Consolidated Appropriations Act of 2020 restored it to the parent’s tax rate. Understanding these changes is essential for proper tax planning.
Are there any exemptions from the kiddie tax?
The kiddie tax does not apply to children below the specified age groups who are married and file joint tax returns. This exemption is important to consider when assessing potential tax liabilities for children. It’s one of the factors parents should take into account for tax planning.
What strategies can parents use to minimize the impact of the kiddie tax?
Parents can employ various strategies to minimize the impact of the kiddie tax, such as using tax-efficient investments, gifting assets with lower income potential, or considering tax-advantaged accounts like 529 college savings plans. These strategies can help parents navigate the tax provision while reducing the tax liability for their children.
Key takeaways
- The kiddie tax prevents parents from avoiding taxes by transferring large gifts of stock to their children.
- All unearned income over the threshold is taxed at the parent’s marginal income tax rate rather than the lower child’s tax rate.
- It applies to all children who are 18 years of age or under or dependent full-time students between the ages of 19 and 24.
- The kiddie tax applies to most unearned income that a child receives and does not apply to any salary or wages.
- In 2022, unearned income under $1,150 qualifies for the standard deduction under kiddie tax law.
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