A parent may elect to include a child's income in the parent's income if the following are true:
- the child's income consists entirely of interest and dividends
- the child's income does not exceed $9,500 for 2011
- no estimated tax payments have been made in the name of the child
- the child is not subject to backup withholding
The election must be made by the due date (including extensions) of the regular tax return.
If the election is made, the parent must pay added tax of the lesser of $95 (for 2011) or 10 percent of the child's income minus $950.
The "kiddie tax" rules do have some advantages, though. One situation in which the election might produce significant tax savings is where the parent is, for example, in the 35 percent tax bracket and cannot deduct investment interest because he or she does not have enough investment income. The election should enable the parent to treat the child's income as the parent's own investment income so that the parent would be able to make use of the interest deduction. Charitable contribution deductions also may be increased.
Another benefit would be relief from having to file the complicated "kiddie tax" form (Form 8615, Tax for Children Under Age 18 With Investment Income of More Than $1,900), especially where more than one child is involved. However, the election involves filing Form 8814, Parents' Election to Report Child's Interest and Dividends, with the parents' annual tax return.
On the negative side, including the child's income could result in a reduction in the parents' deduction for medical expenses, IRA contributions and casualty losses. Also, the income may increase family state income taxes that otherwise would not be payable absent the election.
The "kiddie" tax rules can be an unexpected burden for many families saving for college. However, the following gift-giving strategies can help reduce or even eliminate the kiddie tax and cut the overall family tax bill:
- Buy Series EE bonds for the child and have the child elect to defer tax on the interest as it accrues.
- Invest the child's money in securities with low yields but strong appreciation potential. If the securities are retained until age 18 or later, appreciation during the child's younger years escapes the kiddie tax.
- Invest in raw land with appreciation potential. From the tax viewpoint, the land should be held until the child reaches age 18 or later.
- Buy cash-value life insurance. Inside build-up from the policy will accumulate tax-free.
- If the child is a beneficiary of a trust, coordinate trust income with income from outside of the trust. Although this is a less attractive option, one can still accumulate trust income up to the amount taxed to the trust at the 15 percent rate ($2,300 for tax years beginning in 2011).
- Place UGMA and Uniform Transfers to Minors Act (UTMA) funds in tax-exempt bonds until the child reaches age 18. Tax-exempt zero coupon bonds may be a particularly good way to avoid the kiddie tax and build a college fund. Another approach is to buy stripped municipal bonds.
- Buy market discount bonds for the child, keeping the current yield below $1,900 for 2011 so that the kiddie tax will not apply. When the bond is redeemed (or sold) after the child reaches age 18, the built-in discount will be taxed at the child's rates.
- Set up a gift-giving program that keeps the child's unearned income below the 2011 $1,900 threshold (indexed for inflation) until he or she reaches age 18. For example, a cash gift to a 10-year-old child of $9,000, earning interest at eight percent, could grow over $3,000 by the time the child reaches age 18, and each year's interest will not exceed $1,300. Thereafter, the parent can set aside larger amounts for the child and continue to achieve effective family income-splitting.
- Employ the child in the family business or in the performance of chores supporting the payment of earned income. The income can be sheltered by the standard deduction. Even a young child can perform compensable services.