kiddie tax

In short

A friend of mine once opened a savings account for his daughter and felt proud as a rooster about it. Then a tax form came for her, and he had no idea why. If you are holding stocks, a fund, or a savings account in a child's name, the kiddie tax may apply. It is a rule that taxes a child's unearned income, meaning money from interest, dividends, and investment gains, at the parents' rate instead of the child's low rate. The rule reaches only the part above a threshold set by law, which is the current figure, which the official source publishes each year for the current year. Wages a child earns from a real job are not hit by this rule. The IRS publishes the figures each year in Form 8615 and its instructions, so check the newest version. A few minutes of planning can save a family real money.

The whole of it

What it is

I once watched a grandfather hand his grandson a stock certificate on a birthday, beaming, and nobody at that table had the faintest idea what it might mean at tax time. That is how the kiddie tax catches folks. It is a federal rule meant to stop families from shifting investment income to a child just to use the child's lower tax bracket.

Here is the plain version. Unearned income is money a person gets without working for it, like interest, dividends, and profit from selling an investment. Earned income is pay from a job. The kiddie tax looks only at the unearned kind.

The rule covers children under age the current figure, which the official source publishes each year at the end of the year. It also reaches full time students up to age the current figure, which the official source publishes each year, if their earned income does not cover more than half of their own support. That is the general idea, and the exact conditions are laid out in IRS Publication 929 and in the instructions for Form 8615.

It is a fair thing to want to give a child a head start. The law simply asks that the tax follow the family's rate on the larger amounts.

How it works

If you have ever wondered why a child's account can trigger a tax bill, think of the income in three layers. I find it easier to picture that way, like stairs on a porch.

The first layer is covered by the child's standard deduction for dependents, which is a set amount of income the child may receive with no tax at all. The second layer is taxed at the child's own rate, which is low. The third layer is the part above the threshold, and that part is taxed at the parents' rate. That third layer is where the name comes from.

The IRS sets the dollar lines each year. The exact amounts are in the instructions for Form 8615, titled Tax for Certain Children Who Have Unearned Income. The form figures the tax on the child's unearned income using the parents' tax rates.

Who files what matters too. A child with only a little unearned income might be included on a parent's return using Form 8814, if the rules allow it. Otherwise the child files a separate return and attaches Form 8615. The plan to use one form or the other depends on the child's income and on whether the parent chooses to report it. The instructions for each form spell out who can do what.

It adds up fast. One brokerage account with decent dividends can push a child past the line.

The numbers, and where to find yours

You have probably noticed that these figures move every year, and that is why this guide does not print them as fixed. The amount of unearned income that triggers the rule is the current figure, which the official source publishes each year. The child's standard deduction for dependents is the current figure, which the official source publishes each year. The age cutoff is the current figure, which the official source publishes each year, and the student cutoff is the current figure, which the official source publishes each year.

To find your own numbers, start with the IRS itself. Look at the instructions for Form 8615 and Form 8814 for the tax year in question. IRS Publication 929, Tax Rules for Children and Dependents, walks through the whole matter in plain terms. Your tax software will also ask the right questions and pull in the current figures.

Then gather three facts about your child. Write down how much interest and dividends the child received. Write down any gains from selling investments. Write down the child's earned income, if there is any. With those three facts in hand, the forms become far less scary.

A worked example

A neighbor of mine, a woman named Marisol, set up an investment account for her son Daniel when he was born. Daniel is now 15. He mows lawns in the summer, and he also owns a fund that pays dividends.

This year Daniel earned $2,400 from mowing lawns. That is earned income, so the kiddie tax does not touch it. His fund paid him $3,000 in dividends and he sold some shares for a $1,500 gain. That gives him unearned income of $3,000 plus $1,500, which is $4,500.

For this example, say the threshold line is $2,600 and the child's standard deduction covers the first $1,300. Those are made up round numbers to show the steps, and real figures come from the IRS forms. The first $1,300 of unearned income is covered by the deduction, so no tax applies there. The next $1,300 is taxed at Daniel's own low rate. That leaves $4,500 minus $2,600, which is $1,900.

That $1,900 is the part taxed at Marisol's rate. Say her rate is 24 percent. Then $1,900 times 0.24 is $456. Had it been taxed at a child's 10 percent rate, it would have been $1,900 times 0.10, which is $190. The difference is $456 minus $190, which is $266.

So the rule cost this family $266 more than it would have otherwise. It is not a disaster. Marisol just wished she had known sooner. Next year she can plan around it.

Where it goes wrong

I have seen smart, careful people get tripped up here, and no shame in it. The most common slip is thinking a child's account is a private little bubble with its own tax rules. It is not, since the income is still reported to the IRS under the child's Social Security number.

Another slip comes from mixing up earned and unearned income. A teenager's paycheck is treated differently from the dividends in a fund. If a family lumps them together, the numbers on Form 8615 will come out wrong.

A third trouble is waiting until the filing deadline to gather records. Brokerages send tax statements, and the child's forms need those figures. Missing a statement can mean a late return or an amended one.

Some folks also forget that gifts of investments carry their own rules. When a parent or grandparent gives shares to a child, the child may later owe tax on the gain when the shares are sold. The tax basis is the starting price used to measure the gain. For a gift made during life, the child generally takes over the giver's basis, as Internal Revenue Code section 1015 sets out. A basis that resets to the market value on the date of death applies only to assets passed at death, and a gift made while the giver is alive does not get that reset. A tax professional can explain how that applies to a particular gift.

Finally, the figures and some conditions are set each year, so last year's advice may not fit this year's return. The current IRS instructions for Form 8615 show what applies now.

Questions to answer before you leave this page

Does your child have any unearned income this year, such as interest, dividends, or gains from selling investments? Is that amount above the threshold the IRS lists in the current Form 8615 instructions? Is your child under the age limit, or a full time student within the student age limit, so that the rule applies at all? Have you separated the child's paycheck from the investment income so the right amount gets counted? Do you have the tax statements from every bank and brokerage that holds an account in your child's name? Will the family file Form 8814 with a parent's return, or will the child file with Form 8615? And would a short talk with a tax professional or a careful read of IRS Publication 929 help you feel sure before you file?