Among the many changes brought about by the Tax Cuts and Jobs Act (TCJA) are those pertaining to what is known as the “Kiddie Tax.” These changes may be of special interest to you if you are a young worker and still being claimed as a dependent on your parents’ tax return. If you have children, these changes may also impact your family if your child has earned and unearned income.
In a nutshell, the Kiddie Tax was originally designed to discourage parents (who had the objective of paying less tax) from transferring their investment accounts to their children by taxing the children’s unearned income (dividends, interest and capital gains) at the parent’s highest marginal tax rate. Under the TCJA, however, children’s unearned income is no longer subject to their parents’ marginal tax rate and will instead be taxed at the rates used for trusts and estates. Any earned income (the money received in exchange for work) will now be taxed at the appropriate single tax rates (which are likely much lower). Another benefit of the updated Kiddie Tax is that the new higher standard deduction will apply, allowing for $12,000 of income to be earned before taxes kick in (in comparison to the previous standard deduction of just $6,350).
Keep in mind that the Kiddie Tax applies only to the unearned income of individuals who are:
- Under the age of 18; or
- Age 18 at the end of the year with earned income less than 50 percent of the cost of their support; or
- A full-time student between the ages of 18 and 24 with earned income less than 50 percent of the cost of their support.
For individuals subject to the Kiddie Tax with significant unearned income, there may be little benefit under the new law because the tax rate for estates and trusts (currently topping out at 37%) may be higher than their parents’ top marginal tax rate. There are a couple of strategies which may ease the tax burden in these cases:
- If a child has both unearned and earned income, the earned income could be used to fund an individual IRA account, thereby reducing taxable income while providing an effective investment vehicle.
- A 529 education savings plan could be used as an alternative means for family members to transfer money to a child. Any earnings on this type of account can accumulate tax-deferred and, if they are used later for qualified education expenses, they can be withdrawn with no tax penalty.
Another important point about the Kiddie Tax: There may be state tax laws that apply to minors’ earned and unearned income, so you’ll also want to check to see if there are any specific state rules which need to be taken into account when you are calculating the tax benefit or burden of the changes to this tax law. If you have any questions about the Kiddie Tax, please contact our New York City CPA office in lower Manhattan.