Kiddie Tax

What is Kiddie Tax?

The Kiddie Tax is a tax policy in the United States aimed at preventing parents or guardians from shifting their investment income to their children to benefit from the child’s lower tax rate. Specifically, net unearned income (e.g., interest, dividends, and capital gains) of children under a certain age threshold is taxed at the custodial parents’ highest marginal tax rate rather than the child’s potentially lower rate.

Mechanism of Kiddie Tax

Initially enacted by the Tax Reform Act of 1986, this regulation targets children under age 14. However, legislative changes in recent years have adjusted the ages involved. As of 2021, the Kiddie Tax affects children under age 19, or under age 24 if they are full-time students.

Key Features:

Net Unearned Income: The income subject to Kiddie Tax primarily includes investment income such as interest, dividends, and capital gains.
Threshold: In 2010, the threshold for net unearned income was $1,900. This threshold is subject to annual indexing for inflation.
Rate: The net unearned income exceeding the threshold is taxed at the parent’s highest marginal tax rate.

Historical Context

The original intent behind Kiddie Tax was to curb tax avoidance through income shifting. Parents could theoretically divert income-generating assets to their children to benefit from their lower tax brackets. Kiddie Tax ensures that such shifted income is still taxed at the appropriate rates.

Recent Developments

Recent tax laws, such as those introduced by the Tax Cuts and Jobs Act of 2017, have modified the Kiddie Tax application. Primarily, it altered the taxable rate from being tied to the parent’s tax rate to the typically higher tax rates applied to trusts and estates.

Examples of Kiddie Tax

Case of Unearned Income from Investments:
- Jane, aged 16, earns $2,400 in unearned income from dividends.
- The first $1,000 is not taxed.
- The subsequent $1,000 is taxed at Jane’s rate.
- The remaining $400 is taxed at her parents’ highest marginal rate.
Full-time Student:
- Joe, a 22-year-old full-time student, earns $4,000 through interest.
- His parents are in the 35% tax bracket.
- After accounting for the threshold and applicable deductions, the excess amount is taxed at 35%.

Frequently Asked Questions

Who is Subject to the Kiddie Tax?

Children under the age of 19 or full-time students under the age of 24 who have unearned income exceeding a specified threshold are subject to the Kiddie Tax.

How is the Threshold Amount Determined?

The threshold amount for unearned income is subject to annual inflation adjustments. The amount can be checked in IRS publications for the specific tax year.

What Types of Income are Considered Unearned Income?

Unearned income includes interest, dividends, capital gains, and other investment earnings.

Can Earned Income be Subject to Kiddie Tax?

No, earned income from wages, salaries, and other employment is not subject to the Kiddie Tax.

Marginal Tax Rate: The percentage of tax applied to an individual’s last segment of income.
Unearned Income: Income derived from investments and other sources not related to employment.
Trust Tax Rates: Tax rates applicable to trusts and estates.
Tax Reform Act of 1986: Legislation that significantly revised the federal tax code, including introducing the Kiddie Tax.

Online Resources

Suggested Books

“The Everything Personal Finance in Your 20s and 30s Book” by Howard Davidoff
“J.K. Lasser’s Your Income Tax (2021)” by J.K. Lasser Institute
“Taxes Made Simple: Income Taxes Explained in 100 Pages or Less” by Mike Piper

Fundamentals of Kiddie Tax: Taxation Basics Quiz

### Which of the following describes “net unearned income” under the Kiddie Tax? - [x] Income from investments such as interest, dividends, and capital gains. - [ ] Income earned from the child’s employment. - [ ] Income from part-time entrepreneurial activities. - [ ] All income regardless of source. > **Explanation:** Net unearned income refers to income derived from investments and not from employment or entrepreneurial activities. ### What is the main purpose of the Kiddie Tax? - [ ] To increase the overall tax revenue. - [ ] To discourage investment at a young age. - [x] To prevent income shifting to lower tax brackets. - [ ] To ensure children file independent tax returns. > **Explanation:** The Kiddie Tax prevents parents from shifting income to their children, who are in lower tax brackets, thus ensuring appropriate tax rates are applied. ### At what age does the Kiddie Tax usually stop applying if the child is not a full-time student? - [ ] Age 14 - [ ] Age 21 - [x] Age 19 - [ ] Age 25 > **Explanation:** For non-full-time students, the Kiddie Tax generally applies until the child reaches age 19. ### If a child qualifies as a full-time student, until what age does the Kiddie Tax apply? - [ ] 19 - [x] 24 - [ ] 21 - [ ] 23 > **Explanation:** The Kiddie Tax applies to full-time students until they reach the age of 24. ### Unearned income exceeding which threshold amount was taxable at custodian parents’ rate in 2010? - [ ] $1,500 - [ ] $2,500 - [x] $1,900 - [ ] $3,000 > **Explanation:** In 2010, unearned income exceeding $1,900 was taxed at the custodial parents’ rate. ### How is earned income treated under the Kiddie Tax rules? - [ ] Treated the same as unearned income - [x] Taxed at the child’s own tax rate - [ ] Combined with the parent’s earned income - [ ] Non-taxable under Kiddie Tax rules > **Explanation:** Earned income is taxed at the child’s own tax rate, not under the Kiddie Tax provisions. ### What type of income shifting does the Kiddie Tax aim to prevent? - [ ] Shifting salaries to younger siblings - [ ] Transferring parent-to-child debts - [x] Shifting investment income to lower tax brackets - [ ] Amalgamation of business income > **Explanation:** The Kiddie Tax aims to prevent the shifting of investment income to children who are in lower tax brackets to reduce overall tax liability. ### What change did The Tax Cuts and Jobs Act of 2017 bring to Kiddie Tax? - [x] Taxed unearned income at trust and estate rates. - [ ] Made all unearned income non-taxable. - [ ] Increased the age threshold to 30. - [ ] Reduced the threshold amount to $500. > **Explanation:** The Tax Cuts and Jobs Act of 2017 changed the Kiddie Tax by taxing unearned income at the higher rates applied to trusts and estates. ### How often is the threshold for unearned income indexed? - [x] Annually - [ ] Monthly - [ ] Every five years - [ ] Bi-annually > **Explanation:** The threshold for unearned income is indexed annually to adjust for inflation. ### Which legislative act originally introduced the Kiddie Tax? - [ ] The Affordable Care Act - [ ] The Taxpayer Relief Act - [x] The Tax Reform Act of 1986 - [ ] The Revenue Act of 1935 > **Explanation:** The Kiddie Tax was introduced with the Tax Reform Act of 1986 to prevent tax avoidance through income shifting.

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