‘Kiddie’ Tax Advantages

June 27, 2022  | By David Lowe

Tax considerations are a key part of a successful financial plan, and that’s true of minors as well as adults. A previous blog post explored Roth IRAs as investments to position young workers for future tax savings. However, a child’s wages and investment income (from non-tax-advantaged sources) have tax implications now. One of the key ways is through the Kiddie Tax.

The Kiddie Tax can make some of a child’s unearned income taxable at the potentially higher rate levied on the parent(s), rather than at the child’s marginal tax rate. 

Who falls under the Kiddie Tax?

The Kiddie Tax applies to a child younger than 19 at the end of the tax year – or younger than 24 if the child is a full-time student. For IRS purposes, “full time” means:

• Enrolled for at least five calendar months in the tax year. (The five months don’t have to be consecutive.)
• Enrolled in the number of hours of classes that the school defines as “full time”

For the Kiddie Tax to apply, the child must have at least one living parent. In addition, there is no Kiddie Tax for a child who:

• Is married and files a joint tax return
• Draws more than 50% of his or her financial support from earned income

Kiddie Tax calculations differ somewhat depending on whether the child’s income is investment-only, or a combination of earned and unearned income. Here are some examples.

Only unearned income

If all the child’s income is classified as unearned, the effect is fairly straightforward. For 2022, the first $1,150 is not taxed. The next $1,150 is taxed at the child’s marginal rate. Amounts above $2,300 total – the first $1,150 plus the next $1,150 – are taxed at the rate that applies to the parent(s).

For example, say 17-year-old Jessica had $4,000 of unearned income as short-term capital gains, and she had no earned income. Jessica is in the 10% marginal tax bracket, but her parents (who have much higher income) are in the 24% marginal bracket. Jessica’s total taxes would be:

• First $1,150 = $0
• Then, $1,150 x 0.1 = $115
• Then $1,700 x 0.24 = $408
• Jessica’s total tax liability = $523

“Unearned income” subject to the Kiddie Tax, according to the IRS, includes:

• Taxable interest
• Ordinary dividends
• Capital gains (including capital gain distributions)
• Rent
• Royalties
• Taxable scholarship and fellowship grants not reported on a W-2
• Unearned income as a trust beneficiary

Earned income plus unearned income

There is a bit more math involved for a child who has unearned income and earned income. In this case, the standard deduction is whichever of the following is more:

1. $1,150 or
2. Earned income + $400 (For 2022, no matter how high the earned income, the standard deduction cannot exceed $12,950 for a taxpayer who files as single.)

Returning to the example of 17-year-old Jessica, assume she still has $4,000 of unearned income as short-term capital gains. Now, though, she has started part-time work that will pay $6,000 this year. Here’s how the Kiddie Tax calculation will work:

$6,000 earned income + $400 = $6,400 standard deduction

Of the $6,400 standard deduction, $1,150 applies to unearned income, and $5,250 applies to wages. (Remember that the first $1,150 of unearned income has no tax, and the next $1,150 is taxed at the child’s rate.)

So, taxes on the unearned income =

• $0 on first $1,150
• Then, next $1,150 x Jessica’s rate of 0.1 = $115
• Then, remaining $1,700 x parents’ rate of 0.24 = $408
• Total tax on unearned income = $523

Then, add the taxes on earned income.

$6,000 of wages – $5,250 of remaining standard deduction = $750 of wages x Jessica’s rate of 0.1 = $75

$523 tax on unearned income + $75 tax on wages = total tax liability of $598

How the Kiddie Tax Affects College Savings

The Kiddie Tax does not apply to tax-advantaged college savings vehicles called 529 accounts. UGMA and UTMA accounts, however, are considered the child’s asset, so the Kiddie Tax rules take effect. For example, if 17-year-old Jessica’s parents had opened an UTMA account for her, the first $1,150 of income in the account would be tax free. The next $1,150 would be taxed at Jessica’s marginal tax rate. Income above $2,300 would be taxed at Jessica’s parent’s marginal tax rate.