Definition
The Kiddie Tax refers to a special taxation law in the United States applied to certain unearned income of a child. In particular, it affects those under 19 or full-time students under 24 whose unearned income is above a certain threshold. The aim is to prevent parents from avoiding taxes by transferring assets to their children.
Key Takeaways
- The Kiddie Tax is a tax law applied to unearned income (like dividends, interest, or capital gains) of individuals under 19 years old or full-time students under 24 years old.
- Its purpose is to prevent high-income parents from using their children’s lower tax rate for investment income. Thus, it taxes part of a child’s income over a certain amount at the parent’s tax rate.
- As of 2020, the first $1,100 of a child’s unearned income is tax-free, the next $1,100 is taxed at the child’s tax rate, and any income beyond $2,200 is taxed at the parent’s tax rate.
Importance
The Kiddie Tax is an important finance term because it relates to the tax levied on unearned income (such as investment income) of children under 19 years old or full-time students under the age of 24.
The significance of the Kiddie Tax lies in its potential to impact a family’s overall tax liability.
Traditionally, investment income was shifted to the children in lower tax brackets to minimize tax obligations.
However, the Kiddie Tax rules, designed to prevent high-income parents from avoiding taxes, ensure that a portion of the child’s unearned income is taxed at the parent’s higher tax rate.
Therefore, families must consider this tax when planning investments for their underage children or full-time students.
Explanation
The Kiddie Tax was introduced to prevent high-income parents from exploiting a tax loophole by transferring investment assets to their children who are typically taxed at a much lower rate. Before the introduction of this regulation, wealthy parents often placed income-producing investments under their children’s name, benefiting from their child’s lower tax brackets.
By doing this, they managed to drastically reduce their overall tax liabilities. With the advent of the Kiddie Tax, the government was aiming at ensuring the fair collection of taxes on all possible income produced by a family unit.
This provision ensures that any unearned income over a certain amount, which is generated by a child under a certain age, is taxed at their parent’s higher tax rate instead of the child’s typically lower rate. Usually, this applies to the child’s interest, dividends, and capital gains.
The Kiddie Tax, therefore, upholds the integrity of the tax system by closing off opportunities for tax avoidance. It ensures that wealthy families pay a tax proportionate to their income, regardless of the income source.
Examples of Kiddie Tax
Example 1: John’s son, who is under 18, receives a significant amount of unearned income each year due to the interest on a large inheritance left to him by his grandparents. Although John’s son is a minor, this unearned income becomes subjected to the Kiddie Tax and will be taxed at their parent’s tax rate to prevent parents from shifting their income to their children who are often in lower tax brackets.
Example 2: Susan, a 20-year-old full-time college student, earns dividends from a portfolio of stocks that her parents transferred to her name when she was still a minor. Despite being 20, because she is a full-time student and her earned income doesn’t exceed half of her annual support, the Kiddie Tax applies to her unearned income.
Example 3: Rachel’s 16-year-old son received a large amount from a family member’s life insurance policy. This income exceeds the annual limit for a child’s standard deduction. Because of his age and the type of income, it is subject to the Kiddie Tax, and hence will be taxed at Rachel’s tax rate rather than his son’s lower rate.
FAQ – Kiddie Tax
What is Kiddie Tax?
The Kiddie Tax is a tax law that was introduced in 1986 to prevent parents from using their children’s tax-free or low tax rate to avoid paying taxes on their income. The tax applies to unearned income such as interest, dividends, capital gains, rents, royalties etc. of certain children.
At what age does the Kiddie Tax apply?
Kiddie Tax applies if the child is under 19 years old, or the child is a full-time student under the age of 24, and does not have earned income that is more than half of their own support.
How is the Kiddie Tax calculated?
Initially, the child’s standard deduction is subtracted from their unearned income. If the remaining amount is less than a designated threshold, it is taxed at the child’s rate. Anything above this threshold is taxed at the parent’s marginal tax rate.
Are there any ways to avoid the Kiddie Tax?
Strategies to avoid or reduce Kiddie Tax can include gifting appreciated securities instead of cash, gifting assets that produce tax-free income, or investing in growth stocks that do not pay dividends.
How did the 2017 Tax Cuts and Jobs Act (TCJA) change the Kiddie Tax?
After the 2017 Tax Cuts and Jobs Act, the Kiddie Tax was modified so that a child’s unearned income is no longer taxed at the parents’ tax rate but instead at the rates for trusts and estates, which can potentially be higher.
Related Entrepreneurship Terms
- Unearned Income
- Dependent Child
- Tax Rate Structure
- Investment Interest
- Income Shifting
Sources for More Information
- Internal Revenue Service (IRS): The IRS website is a reliable source for understanding more about the Kiddie Tax as it provides official tax guidelines.
- Investopedia: Investopedia provides easy-to-understand information and definitions of various financial terms including the Kiddie Tax.
- The Motley Fool: The Motley Fool website has many articles related to personal finance and tax laws, including the Kiddie Tax.
- BankRate: BankRate provides a wealth of information on finance and money matters and is a good source for information on the Kiddie Tax.
