What is Kiddie Tax, How Does it Work, and How Do You Know If You Need to Pay It?
It’s about to be tax season again, which means preparing your taxes for the upcoming year. However, there may be some confusion on how all the kiddie tax laws affect you, and this can make filing for the upcoming year a bit tricky. That’s why we’ve deciphered what is and isn’t a deduction subject in the 2022 tax season, so you don’t get an unwelcome surprise when you file next year.
The most common confusion about the kiddie tax is whether or not children may have to pay taxes on the money they make from a part-time job. It’s enough that parents have to worry about their school, clothes, and everything else, especially if they have low incomes. And now taxes?
Yes, unfortunately, this is true. However, not all funds are taxable, and we’ll explain how the kiddie tax works, who needs to file it, and what you can do if your dependent child may need to pay taxes on their income.
The kiddie tax is an act of the Internal Revenue Service (IRS) under topic No.553a). It’s an alternative method to the way children are taxed when their income is above the standard deduction. It can be pretty tricky, so let’s take a moment to examine how the kiddie tax works and how it can affect your children in a financial sense.
What Is the Kiddie Tax?
The Kiddie Tax was enacted as a section of the Tax Reform Act of 1986 under the Internal Revenue Code (IRC). It was first legislated for the tax-paying season after December 31 of the same year. It was initially covering children under the age of 14. At the time, it was illegal for kids to work, but they could have bonds and receive dividends. Soon after, tax authorities realized that the parents and legal guardians were using the fact of shifting assets to kids and taking advantage of their children’s lower taxes.
Today, the Kiddie Tax is how the IRS handles the income taxes on unearned income for minors (under 18 years of age) who have investments like stocks and bonds. Kiddie Tax was designed to discourage parents from transferring income-producing assets into the name of their kids to benefit from the child’s privileges. Nonetheless, in 2020 the Further Consolidated Appropriations Act changed the taxable income rate to the parent’s tax rate.
How Does the Kiddie Tax Rule Work?
Kiddie Tax is designed to deduce a tax regime for a child’s unearned income. It refers to taxable interests, capital gains, dividends, rents, investment incomes, and royalties. Kiddie Tax Rule applies to any unearned income that surpasses a certain threshold of unearned income in any given year.
So what income and who is subject to kiddie tax? That’s a good question since many parents worry that if their child finds a part-time job, they will have to pay tax on that income. The truth is that the law applies to any unearned income that a child receives and exceeds $2,200—that’s right, it doesn’t matter if they’re under 18, 19, or even 21 after the tax year.
But, the first $1,100 is not taxed because of every child’s standard deduction. But, be that as it may, the second part of the equal sum is taxed at the child’s marginal rate. Hence, the name kiddie tax. But what happens with the kiddie tax rule when the amount exceeds $2,200 (for the tax year 2021)? In that case, your child’s unearned income is taxed at a higher parents’ rate.
So does your child have to pay these taxes? Not necessarily. There is another option, you, as a parent, can elect to include your child’s interest, ordinary dividends, and capital gain on your income tax return.
If you choose, your child does not have to file a return. But that also means that the federal income tax may be higher. c)
The Kiddie Tax applies to your children if they meet the following criteria:
- Seventeen years old or under at the end of the tax year since support obligations do not apply to minors under 18.
- Eighteen years old at the end of the tax year, only if their earned income is lower than or equal to 50% of their support.
- If their earned income is less than or equal to half of their support and they are full-time students, they are 19-23 years old.
What does Kiddie Tax Rule Include as Unearned Income?
There is often confusion about what falls into unearned income. Each parent in the US has a different situation, sometimes a unique one. Therefore a lot of mal-interpretations of the kiddie tax rule appeared online. The unearned income includes any assets that do not come from providing services or working, in other words. So what exactly counts as unearned income?
IRS includes the following under the unearned income:
- capital gains (profits made when you sell an asset),
- taxable scholarships,
- the income produced by gifts from grandparents,
- income from UGMA and UTMA accounts,
- rental income,
- and royalties.
It can also include non-reported Form W-2 taxable social security benefits b), annuity income, and fellowship grants.
How is kiddie tax calculated? For example, let’s say your child has $2,200 in unearned income. The first half of it, or $1,100, is not taxable. Then, another $1,100, or the second half, is taxed at your child’s rate. However, if unearned income surpasses $2,200, everything above that amount triggers kiddie tax and is taxed at your rate as a parent. In the past, parents used low taxes for their kids to transfer their assets and pay almost zero taxes on unearned income.
That’s changed with the kiddie tax rule, and if parents transfer their funds, for example, stocks they sold, they will, either way, pay taxes if it surpasses the amount of $2,200 at their rate. The only exemptions from the kiddie tax are for kids who make enough money to support themselves and the kids who are married and filing joint returns. Another would be for children with no living parents at the end of the tax year.
Are Scholarships Considered Unearned Income?
The kiddie tax doesn’t affect most scholarships. However, there are differences. According to the IRS, only taxable scholarship and fellowship grants not reported on Form W-2 are considered unearned income and therefore are taxable.
Under the scholarship term, the IRS considers an amount paid to a student at an educational institution for the sole purpose of the study. Fellowship grants work similarly, only including research besides the study purposes.
However, there are other types of grants, such as need-based ones, including Pell and Fulbright, which can count as taxable income under certain circumstances. But, mind you, there are some exceptions, and emergency financial aid grants are not subject to tax.
What About Earned Income?
Earned income is not a subject of the kiddie tax rule. For example, your child works or has a part-time job over the summer. However, it must only be reported for tax return if it exceeds $12,550.
If you’re a parent with a child under the age of 19, you may wonder what is and isn’t considered earned income for reporting purposes. Earned income includes:
- Net earnings from self-employment,
- Taxable alimony.
So, if your kid’s earned income is less than $12,000 per year, you don’t have to report it on your tax return or theirs. However, if a child is a minor and has no unearned income, only earned, they must file a tax return for sums surpassing $12,550.
Who Must File Kiddie Tax?
If you wonder whether or not your teenager must file taxes, the answer is yes. It’s a known fact that children under 18 are not legally allowed to file taxes. That means a kiddie tax is filled by a parent in the child’s name. If your child is over 18, they file their taxes alone.
But you must know a few things before letting them file their form.
- First, your child can file their taxes. Naturally, you will fill out the form if they are younger than 16. But there are also some additional costs when filing independent taxes.
- Second, you can elect to file your child’s interest, ordinary dividends, and capital gains on your return. But, if you make this choice, your child won’t have to file a tax return. In addition, you will have to file additional forms, which may affect your eligibility for some credits.
So, before making any decision, it is best to research the options and possibilities that come with it. Then, if you are unsure, consult your financial advisor or call the IRS directly and inquire about the kiddie tax rules.
To recap, the kiddie tax refers to children who make an unearned income that exceeds a certain amount, and it a subject to taxation. The kiddie tax rules apply if your child is under age 19 or a full-time student under age 24 at the end of the tax year.
Kiddie Tax Form Explanation
Form 8615 is a document to help you pay taxes on your child’s unearned income. As already mentioned, any income gained without providing any services is considered taxable income by the kiddie tax rule. Therefore, if your child only has earned money, for example, through a part-time job or self-employment, and is less than $2,200, you do not need to file Form 8615.
However, when the child’s income surpasses these figures, some parents may choose to record their child’s unearned income on their tax returns. However, there are often when unearned income is unknown. Hence a parent and child must file a request for an extension due to the circumstances. That means filling out another form, 4868. But, you must be aware that according to the IRS, an extension of time does not mean the payment due date will also be prolonged.
Kiddie Tax Rules: Are Your Child’s Investments Taxable Income?
Unfortunately, they are if they surpass the sum defined by the kiddie tax rule. Many parents want the best for their children and decide on investment options. According to the IRS, a child’s investment income is taxable regardless of how they acquired it—whether by earning it themselves or through gifts from their parents.
The kiddie tax is the income tax collected on unearned income, such as investment income, that a child receives. The kiddie tax applies to children aged 19 or under at the end of the year whose unearned income exceeds $2,200. Perhaps, you already know, but some parents are too eager to provide a head start for their children that they forget about taxable income.
What are Your Options?
To reduce your exposure to the kiddie tax, consider investing in investments that do not pay dividends or interest until your children have passed the kiddie tax window. Also, consider that investments grow in value over time. But, eventually, you will want to sell them. Again, a financial advisor can help you comprehend these investment kinds and make appropriate recommendations for your family’s situation and goals.
Suppose you are not worried about the kiddie tax, then don’t change your child’s existing situation. You made your choice to consciously invest in their name to provide them with enough funds to have a jumpstart in life. The only thing you should do if you have not already, is teach them about finances. Because if you give them funds, it means nothing if they do not understand how it all works, even taxes and kiddie tax rules.
Financial literacy is essential, in large part because it helps you make sound financial decisions. You can learn to improve your financial literacy skills. It’s not something that you’re born with; it’s a skill that can be taught and learned over time.
A child’s ability to make sound, responsible money decisions will affect their future success and happiness for the rest of their lives. Kids who are taught how to manage money early on will have an easier time when they have more responsibilities later in life (like paying for college).
A good way for parents and kids alike to start learning about managing money early on is by opening up a savings account together. Then, when your child sees that there are things they want or need but don’t have enough money for them yet, they’ll know what steps they need to take!
BusyKid is a financial literacy companion for kids that helps them understand the power of money and how to manage their allowance or any earned money. It also encourages kids to save and invest and make money doing chores. BusyKid is for ages 8 through 17. It’s a safe and secure environment for kids to learn about money management. BusyKid gives kids their app account, which allows them to manage their money and track spending.
BusyKid also allows kids to earn money by doing chores and completing tasks. Kids can even use the app to invest in stocks and bonds, which helps them learn how to manage their money wisely. The app is easy for kids to use and is available on any device. BusyKid also allows parents to monitor their child’s spending and earnings.
It allows users to purchase fractions of stocks or bonds in companies they know or want to learn more about. With BusyKid, your child can buy some supplies, which are not considered taxable income under the kiddie tax rule. Learning about money and the meaning of taxes helps children understand how stocks work without worrying about a significant tax burden at this point in their lives. Using BusyKid, parents can teach their children valuable lessons about investing while protecting them from unnecessary expenses.
The kiddie tax rules can be confusing, but parents must understand how they work, to the minor point. Not only do parents need to think about investing in a particular child’s name, but they also need to consider the long-term implications of the child’s future. Grandparents are especially keen to provide their grandkids with insurance that will last into the future.
But, you as a parent must know how kiddie tax rules might affect your child’s investment, including the percentage that will be deduced from that income, because in the end, you are paying it. If your child or teen has earned income, they may need to pay taxes.
Like most things, the kiddie tax rules are complicated. There are many ways to reduce your tax liability, but it needs the knowledge of a person who is an expert in that area. Perhaps consulting your financial advisor and addressing your problem can lead to a good solution. Hopefully, this clears up some questions about the kiddie tax.
- a) Internal Revenue Service. Topic No. 553 Tax on a Child’s Investment and Other Unearned Income (Kiddie Tax)
- b) Internal Revenue Service. Instructions for Form 8615 (2021) Unearned Income
- c) Internal Revenue Service. Form 8814. Parent’s Election To Report
Child’s Interest and Dividends