The IRS’s kiddie tax rules limit parents’ ability to transfer investment assets to a minor child in order to take advantage of the child’s lower marginal tax bracket.
The kiddie tax applies to the following groups:
- Children under age 18
- Children age 18 whose earned income doesn’t exceed one-half of their support
- Children under age 24 who are full-time students and whose earned income does not exceed one-half of their support (A student is considered full-time if he or she is a full-time student during any part of at least five months during the year.)
Children subject to the kiddie tax are taxed at their parents’ marginal tax rate on any unearned income over an amount indexed for inflation. For 2017, this amount is $2,100. (The first $1,050 of unearned income is tax-free under the child’s standard deduction, and the second $1,050 is taxed at the child’s marginal rate.)
There are two ways to apply the parents’ marginal tax rate to the child’s income:
- Include the income on the parents’ return (certain conditions must be met in order for this option to be available); or
- Report the income on a return for the child, with a special calculation on IRS Form 8615.
Before reporting the income on the parents’ return, you should consider running the numbers to determine if that extra income could mean the reduction or loss of some tax deductions and credits that are phased out as income grows. Additionally, this process will help determine the reporting method that will allow you to pay the least possible tax on the child’s investment earnings.
Tax planning strategies
- Consider investments that potentially generate tax-exempt income, such as municipal bonds*; investments that defer tax, such as U.S. savings bonds; or growth-oriented stocks and growth securities.
- If taxable investment income does not exceed the $2,100 threshold, consider electing to report U.S. savings bond interest each year.
- If the child has earned income, consider investing the assets that are generating taxable investment income in a Roth IRA. Roth IRA qualified distributions generally aren’t subject to income tax.
If you decide on the third option, bear in mind that your contributions are not tax deductible because you can invest only after-tax dollars in a Roth IRA. If you meet certain conditions, your withdrawals will be free from federal income tax, including both contributions and investment earnings. To be eligible for these qualifying distributions, you must meet a five-year holding period requirement and one of the following must apply:
- You have reached age 59½ by the time of the withdrawal.
- The withdrawal is made because of disability.
- The withdrawal (of up to $10,000) is made to pay first-time homebuyer expenses.
- The withdrawal is made by your beneficiary or estate after your death.
*Municipal bonds are federally tax-free but may be subject to state and local taxes, and interest income may be subject to federal alternative minimum tax (AMT).
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.
© 2016 Commonwealth Financial Network®