Kiddie Tax is a U.S. tax rule that applies higher tax rates on unearned income of children to prevent income splitting for tax advantages.
Kiddie Tax is a tax regulation in the United States designed to tax the unearned income of children under a certain age at the parent's tax rate. Specifically, it applies to a child’s unearned income such as dividends, interest, and capital gains that exceed a certain threshold. This rule aims to discourage families from shifting income to children who may be in lower tax brackets, thus preventing tax avoidance through income splitting. In finance and wealth management, Kiddie Tax is critical when structuring investments and trusts that benefit minor children. It impacts how distributions, dividends, and capital gains are reported and taxed when they accrue to minors. The tax applies to children under age 19, or under 24 if a full-time student, with unearned income over the threshold amount. Unearned income above this threshold is taxed at the parents' marginal tax rate instead of the child's rate.
Understanding Kiddie Tax is essential for wealth managers and family office professionals in crafting tax-efficient inheritance and investment strategies. When assets generate unearned income for minors, the Kiddie Tax rules can significantly increase the tax burden by applying parents’ higher tax rates to the child’s unearned income. This affects decisions around gifting, trust fund distributions, and custodial account planning. Complying with Kiddie Tax regulations ensures accurate reporting and avoids unexpected tax liabilities. Incorporating this knowledge into tax planning helps optimize after-tax returns and supports effective governance of family wealth, especially when managing portfolios or distributions involving minors' income.
Consider a child under the age of 19 who has $3,000 in dividend income in a year. The standard unearned income threshold is $2,300 (for example). The first $1,100 is tax-free (standard deduction), the next $1,200 is taxed at the child's rate, and the remaining $700 is taxed at the parent’s marginal tax rate of 35%. So, $700 of the income is taxed at 35%, increasing the child’s overall tax liability.
Kiddie Tax vs Dependents' Taxation
Kiddie Tax specifically targets unearned income of minors at parents’ tax rates to prevent income shifting, whereas dependents' taxation more broadly includes rules around how children and other dependents are taxed on their income, including earned income. Kiddie Tax applies primarily to investment income and gains, while dependents’ taxation covers both phase-outs of exemptions and different filing statuses for dependents.
What types of income are subject to Kiddie Tax?
Kiddie Tax applies to unearned income, including interest, dividends, capital gains, and other investment income received by a child under certain age limits.
At what age does Kiddie Tax no longer apply to a child?
Kiddie Tax applies to children under age 19, or under 24 if they are full-time students. After these ages, the child’s income is taxed normally at their own rates.
How does Kiddie Tax impact trust funds for minors?
Trust distributions to minors that include unearned income can trigger Kiddie Tax if the income surpasses thresholds. Wealth managers must structure trusts carefully to manage the tax implications.
