Child's Unearned Income Can Trigger 'Kiddie Tax'

By Marcia Richards Suelzer, Toolkit Staff Writer

Parents may not realize how tax rules can affect the taxation of their child's investment income. If your son or daughter has more than $1,900 of investment (not earned) income, that income might be taxed at your tax rate, rather than your child's tax rate as a result of the "kiddie tax" rules.

The "kiddie tax" was enacted back in 1986 to prevent high-income parents from shifting income to their lower-income-taxed children, thereby reducing the family's overall tax liability. Initially, the provision's nickname, "kiddie tax," seemed to fit: it applied only to children who were under age 14 at the end of a calendar year.

But law changes have expanded its reach to teenagers and young adults, making it an issue for an increasing number of families.

Example. Daddy Warbucks transfers all his shares of several biotechnology stocks to his 16-year-old daughter, Annie. During the year, Annie receives $5,000 in dividends. Annie has no earned income. Without the kiddie tax, the $5,000 of dividend income would be taxed at Annie's 10-percent tax rate, rather than Daddy's 35-percent tax rate. However, because of the kiddie tax rules, Annie's income is taxed at Daddy's tax rate.

When Does the Kiddie Tax Kick In?

It would not be that hard to trigger the kiddie tax if you have a growing college fund for your child. Still, You only need to worry about the kiddie tax if you answer "yes" to all of the following questions.

1. Does my child have unearned income? The kiddie tax applies only to unearned income, such as interest, dividends and capital gains. Distributions from trusts are generally considered unearned income.
2. Is the amount of unearned income $1,900 or more? Only unearned income is taken into account. The kiddie tax never applies to a child's earned income.
3. Does the child meet any of the following age tests?
• The child was under age 18 at the end of the year,
• The child was 18 at the end of the year and did not have earned income that was more than half of his or her support, or
• The child was over age 18 but under age 24 at the end of the year and
  • was a full-time student, and
  • did not have earned income that was more than half of his or her support

If you answered "yes" to these questions, then you have some math homework to do before you can file your tax return. You need to determine whether you should elect to claim your child's income on your own return, or whether you should have your child claim it on his or her return.

Electing to Claim the Income on Your Return

Whether your child reports the income on his or her return, or you report it on your return, unearned income over $1,900 is going to be taxed at your tax rate. In recognition of this, the IRS allows the parent to elect to report the child's unearned income provided:

• your child is under 19 (24 if a full-time student) as of December 31st
• the child's only income is from interest or dividends, and
• the child's gross income was $9,500 or less.

Assuming that you can do so, should you elect to report it on your return and avoid the aggravation of filing a return for your child?

The answer depends upon your overall tax picture. Adding the child's income to your own will have an impact on any deductions or credits that have limitations based upon adjusted gross income, such as miscellaneous itemized deductions, casualty losses or education credits. If the child's income is substantial and you are close to those limitations, then you will want to calculate the impact both ways. It also depends upon the source of the child's income. If the unearned income is from qualified distributions and/or capital gain distributions, then you may pay $95 more in tax because you'll lose the advantage of the lower rates on the income between $950 and $1,900.

If the numbers work out, you make the election by filing Form 8814, Parents' Election To Report Child's Interest and Dividends, with your tax return. Otherwise, you would complete Form 8615, Tax for Certain Children Who Have Investment Income of More Than $1,900, and attach it to your child's federal income tax return. More information can be found in IRS Publication 929, Tax Rules for Children and Dependents.