kiddie tax and children's investment income

In short

A friend of mine opened a small investment account for his daughter and felt proud of it for about a year. Then tax season came, and he learned the account had a tax story of its own. If you are holding shares for a child, the child's investment income may be taxed at the parents' rate once it passes a set amount. That rule is called the kiddie tax. The first slice of a child's unearned income is tax free, and the next slice is taxed at the child's own low rate. Anything above that is taxed as if the parents earned it. The official limits change by year, so check the current figures on the IRS pages before you file. Many families use Form 8615 to do this math, and the IRS explains it in Publication 929.

The whole of it

What it is

I once watched a grandfather hand his grandson a stock certificate on a birthday. He felt wonderful, and he should have. Giving to a child is a fine impulse. The tax code simply has a rule about what happens next.

The kiddie tax is a rule that taxes a child's unearned income at the parents' rate when that income gets large enough. Unearned income means money the child did not work for, such as interest, dividends, and gains from selling investments. Lawmakers wanted to stop families from moving investments into a child's name just to get a lower tax rate. So the rule steps in.

The rule applies to a child who is under age the current figure, which the official source publishes each year at the end of the year, with some added cases. A child who is that age or older may also fall under it if a full time student under a higher age cutoff, and if the child's earned income does not cover more than half of their own support. The IRS lays out these age tests in Publication 929 and in the instructions for Form 8615.

Earned income is treated differently. Wages from a summer job are taxed at the child's own rate, the same way anyone else's wages are. The kiddie tax looks only at the unearned side.

How it works

A neighbor of mine liked to say that a rule gets easier once you see its three steps. Here are the three steps. They come in layers, like a cake.

The first layer is tax free. The child has a standard deduction for dependents, and part of the unearned income is covered by it. The IRS sets that figure each year, and it is the current figure, which the official source publishes each year.

The second layer is taxed at the child's own rate. Once the first amount is used up, the next amount of unearned income is taxed at the child's own bracket. This layer is also tied to a yearly limit, the current figure, which the official source publishes each year. That tends to be a low rate.

The third layer is where the rule bites. Any unearned income above those two layers is taxed at the parents' marginal rate. The marginal rate is the rate on the last dollar the parents earn. So a child with a lot of investment income may pay tax the way the parents would.

The family reports this on Form 8615, which the child attaches to the child's own return. In some cases the parents may choose to report the child's income on their own return using Form 8814. That choice has limits, and the IRS describes them in the form instructions. The tax on the child's income is the child's to pay, though a parent usually handles the paperwork for a young child.

The numbers, and where to find yours

You have probably noticed that the dollar limits move from year to year. That is by design, since they are adjusted for inflation. So this guide does not print a figure as if it were permanent.

The unearned income threshold is the current figure, which the official source publishes each year. The age limit is the current figure, which the official source publishes each year. The parents' rate depends on their own taxable income and filing status, which you find in the current year's tax rate schedules.

For the live figures, go to the IRS. Publication 929, Tax Rules for Children and Dependents, is the main guide. The instructions for Form 8615 walk through each line. The IRS also posts yearly inflation adjustments on its site, and those carry the current limits and the dates they took effect.

If more than one parent is involved, the rule picks a specific parent's rate. The form instructions explain which one, based on whether the parents are married and filing together or apart. Read that part with care.

A worked example

Let me tell you about Marcus and Elena, a couple I will invent for the sake of the numbers. They have a daughter named Priya, age 10. Priya holds a small investment account that a grandmother gave her. This year the account paid $2,400 in dividends and interest. Priya had no earned income.

Say, for this example only, that the first layer is $1,300 and the second layer is another $1,300. Those are plain figures chosen for the story. They are not the current limits, so check the IRS for the real ones.

Start with the total. Priya had $2,400 of unearned income.

The first $1,300 is tax free. That leaves $2,400 minus $1,300, or $1,100.

The next $1,300 would be taxed at Priya's own rate, but only $1,100 is left. So the whole $1,100 falls in the second layer. Suppose Priya's own rate on that layer is 10 percent. Then the tax is $1,100 times 0.10, which is $110.

Nothing remains for the third layer. Marcus and Elena's higher rate never comes into play. The family owes $110 on Priya's income.

Now suppose a better year. The account pays $5,000. The first $1,300 is tax free. The next $1,300 is taxed at 10 percent, which is $130. The rest is $5,000 minus $1,300 minus $1,300, or $2,400. That $2,400 is taxed at the parents' rate. If the parents' marginal rate is 24 percent, the tax is $2,400 times 0.24, which is $576. The total is $130 plus $576, or $706.

See how the shape changes? Same child. Same account. A bigger year pulled in the parents' rate.

Where it goes wrong

I once watched a careful man file a return and leave out his son's dividends, because the account was in his son's name and he figured it was the boy's business. It was the boy's income. It was also a reportable one. The 1099 forms go to the IRS, and the match tends to catch the gap.

The first trap is forgetting that a child's account is still taxable. A child with enough income may have to file a return, and a young child's return is signed by a parent.

The second trap is using last year's limits. They change. Check the current numbers every season.

The third trap is the filing choice. Reporting a child's income on a parent's return with Form 8814 can raise the parents' own tax in ways that surprise people, so the family should read the form's rules first. Sometimes a separate Form 8615 works out better.

The fourth trap is the age rule. A child close to the age cutoff, or a student, may land in or out of the kiddie tax in a way that is not obvious. Read the Publication 929 tests, and do not guess.

State taxes are a separate matter. Your state may have its own rules for a child's income. The state tax agency's website is the place to look.

Questions to answer before you leave this page

Have you looked up the current kiddie tax limits on the IRS site, or are you working from an old number? How much unearned income did your child's accounts earn this year, and does it pass the first layer? Does your child fall under the age test, or the student test in Publication 929? Which parent's rate would apply to the third layer, given how your family files? Would Form 8615 on the child's own return or Form 8814 on yours cost less, once you run both with real figures? And does your state tax a child's investment income in a way that differs from the federal rule?