What is the kiddie tax?
When a kid receives income for doing nothing, they’re at risk of triggering the kiddie tax, which the child’s parent or guardian will then have to pay.
Under the kiddie tax, if a child is holding income-generating assets, and that income is above $2,500 for the year, their income is taxed at their parent or guardian’s marginal income tax rate. Investment or other unearned income in the form of capital gains, dividends and interest count.
The kiddie tax threshold is $2,500 in 2023 and $2,600 in 2024. In other words, in 2023, a parent or guardian would have to pay income taxes on their child’s investment income above $2,500 at their income tax rate, not their child’s (which is likely lower).
How does the kiddie tax work, and who does it apply to?
Unearned income could take the form of distributions from investments in a custodial account, custodial Roth IRA for kids, or ABLE account, for instance. People with investment income who are under the age of 18, or dependent students between the ages of 19 and 24, are taxed as follows for 2023:
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The first $1,250 of unearned income is tax free.
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The next $1,250 of unearned income is taxed at 10%, the lowest tax bracket for income tax filers.
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Any unearned income above $2,500 will be taxed at their parent’s marginal rate.
Don’t forget to use IRS Form 8615 to file any unearned income.
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Why the kiddie tax? What’s the story?
The kiddie tax was first enacted as a part of the 1986 Tax Reform Act. The purpose of the kiddie tax is to make sure assets gifted to children above a certain threshold are taxed at their parent’s rate.
Imagine you bought a share of stock for $50 that’s now worth $100, and that you’ve held the share for more than a year. If you sell the share, you’ll be taxed at capital gains tax rates based on your income: 0%, 15%, or 20%. But if you give that stock to a child whose income is lower than yours, they could likely sell it at a lower capital gains rate than you. The kiddie tax is meant to prevent adults from realizing these lower capital gains by funneling investments through minors.
So, in this scenario, if the sale of that stock netted more than $2,500, the capital gains tax amount above that would be based on the parent’s income, not the child’s. The knock-on effect of this is that parents now must be aware of any unearned income in their dependents’ investment account, even if they’re not trying to pull one over on the IRS.
The bottom line
If you want to pass down generational wealth, talking to a tax professional may help you figure out the most tax efficient way to do so. The kiddie tax reminds us that receiving investments as a gift isn’t always free, especially if that investment’s realized gains or annual unearned income are over $2,500.
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Next steps
Source: nerdwallet.com