Kiddie Tax Explained: A Comprehensive Guide for Parents

Posted on September 10, 2023

Parents need to be aware of the Kiddie Tax, a provision that was instituted in the United States to prevent parents from taking advantage of their children’s tax-free status. The tax affects minors’ unearned income and can have significant financial consequences for their families. In this blog post, we’ll explain what the Kiddie Tax is, how it works, and what steps small business owners can take to minimize its impact on their taxes.

What is the Kiddie Tax?

The Kiddie Tax is a tax provision that applies to unearned income for children up to age 24 assuming they meet certain criteria. It will apply to most children aged 18 or under. For someone aged 19-23 the kiddie tax would apply if they are a student for that year. The kiddie tax would never apply to someone 24 or older.

There are four primary criteria for the application of the kiddie tax, including:

  1. the child not filing a joint return for the year
  2. at least one parent being alive at year’s end
  3. the child’s net unearned income for the year exceeding the threshold for that year
  4. the child falling under specific age rules

This tax is applied to children’s unearned income (including capital gains, interest, and dividends) that exceeds a certain amount. This provision was introduced in 1986 to combat a tax loophole where parents would invest in their children’s names to take advantage of their lower tax rates.

How Does the Kiddie Tax Work?

It taxes unearned income at a higher rate than normal. In 2023, the first $2,500 of a child’s net unearned income is tax-free. If the child’s net unearned income exceeds that then the amount that exceeds the threshold would get hit with the kiddie tax, which is generally the parents marginal tax rate. 

You calculate the kiddie tax using IRS Form 8615.

 

How Can Small Business Owners Minimize the Impact of the Kiddie Tax?

While the Kiddie Tax rules can seem daunting, there are several tactics that you can employ to minimize its impact on your child’s investment earnings:

  • Stay Below the Threshold
    • Simply put, keep the unearned income of your child under the annual threshold and no kiddie tax applies!
  • Choose Your Investments Wisely
    • Opt for investments that yield minimal or no dividends, like growth stocks or tax-efficient mutual funds, to keep unearned income low.
      • Consider Series EE U.S. Savings Bonds: The interest income from these bonds is tax-deferred until they are redeemed. So, if the bonds are cashed when your child is not subject to the Kiddie Tax, it will not apply.
      • Utilize a Section 529 College Savings Plan: Withdrawals from a Section 529 plan are exempt from federal income tax as long as they’re used for eligible education expenses.
      • Invest in Life Insurance Products: Investment accounts bundled with life insurance products like universal life policies offer tax-deferred growth and can be borrowed against to cover college costs.
  • Encourage Earned Income
    • The Kiddie Tax doesn’t apply to children aged 18-23 if their earned income surpasses 50% of their yearly support.

Conclusion

In conclusion, the Kiddie Tax is an important provision that small business owners need to be aware of. It can have significant financial consequences for business owners who have children with investment income. To minimize the impact of the tax, small business owners should take steps to generate less unearned income and work with a qualified financial advisor or tax professional who can help them navigate the complexities of the tax system. With careful planning and informed decision-making, small business owners can reduce their tax liability and achieve financial stability in the face of the Kiddie Tax.

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