Unearned income usually refers to income in the form of interest, dividends, and capital gains. In the context of the kiddie tax, these types of income often come from custodial accounts that parents or grandparents set up and fund for younger children. Don’t worry, the kiddie tax will not affect your high schooler’s part-time paycheck. The kiddie tax is only assessed on a child’s (or young adult’s) unearned income. Earned income from a job or self-employment is never subject to the kiddie tax.
The so-called “kiddie tax” can cause some of a child’s unearned income to be taxed at the parent’s higher marginal federal income tax rates instead of at the usually much lower rates that a child would otherwise pay.
This is meant to combat income shifting to save on taxes—in this case, the process of moving income from a parent or custodian’s higher tax bracket into the child’s lower tax bracket. For purposes of this federal income tax provision, a “child” can be up to 23 years old. So, the kiddie tax can potentially affect young adults after their 18th birthday.
Perhaps the most important thing to know about this poorly understood provision is that, for a student, the kiddie tax can be an issue until he or she turns 24. For that year and all future years, your child is finally kiddie-tax-exempt.
Calculating the kiddie tax
The first step to determining the kiddie tax is calculating the child’s taxable income.
- Child’s Net Earned Income + Child’s Net Unearned Income – Child’s Standard Deduction = Child’s Taxable Income
The portion of taxable income that consists of net earned income is taxed at the regular federal income tax rates for single taxpayers.
The portion of taxable income that consists of net unearned income that exceeds the standard deduction ($2,600 for 2024 or $2,500 for 2023) is subject to the kiddie tax and is taxed at the parent’s higher marginal federal income tax rates.
The tax is calculated by completing an IRS form, which is then filed with the child’s Form 1040.
Is your child exposed?
Maybe. For 2023, the relevant IRS form must be filed for any child or young adult who:
- Has more than $2,500 of unearned income.
- Is required to file Form 1040.
- Is under age 18 as of December 31, 2023, or is age 18 and didn’t have earned income in excess of half of his or her support, or
- is between ages 19 and 23 and a full-time student and didn’t have earned income in excess of half of his or her support.
- Has at least one living parent; and
- Didn’t file a joint return for the year.
For 2024, the same rules apply except the unearned income threshold is raised to $2,600.
Don’t let the kiddie tax sneak up on you
The kiddie tax rules are quite complicated, and the tax can sneak up on the unprepared. The Wegner CPAs tax experts can determine if your child is affected and suggest strategies to minimize or avoid the tax. For example, in certain situations, we may recommend your child invest in growth stocks that pay no or minimal dividends and hold on to them until the kiddie tax no longer applies.
Don’t be caught off-guard! Calculating and reporting the kiddie tax can be a complicated process. The tax team at Wegner CPAs is well-equipped to help you navigate the process. For more information, reach out to your advisor.
