The Kiddie Tax: Changes That We All Need to Know About

Under the Tax Cuts and Jobs Act (“TCJA”) of 2017, Congress enacted a change to the commonly called “Kiddie Tax” rules, to prevent parents and grandparents in high tax brackets from shifting income (especially from investments) to children in lower tax brackets.

“Kiddie Tax” in Plain English

The “Kiddie Tax” was first enacted in 1986 to prevent parents from shielding income by placing investment accounts in the names of their children, who typically are in lower income tax brackets. Initially, the Kiddie Tax applied up to when a child turned 14. In 2008, the threshold increased to cover children through age 18 and full-time students through age 23.

The Age Factor

Under the new rules as modified by TCJA, the Kiddie Tax can potentially apply until the year that a child turns age 24 as it now may apply when all four of the following requirements are met during a tax year:

1. The child does not file a joint return for the year.
2. One or both of the child’s parents are alive at the end of the year.
3. The child’s net unearned income for the year exceeds the income filing threshold for that year, and the child has positive taxable income, net of any applicable deductions such as the standard deduction. The unearned income threshold for 2018 is $2,100. If unearned income does not exceed the threshold, the Kiddie Tax does not come into play. If the threshold is exceeded, only unearned income in excess of the threshold is considered in the calculation.
4. Age-related rules:
   
   Rule 1. The child is 17 or younger at year-end.
   Rule 2. The child is 18 at year-end and does not have earned income that exceeds half of his or her support.
   Rule 3. The child is age 19 to 23 at year-end and (a) is a student and (b) doesn’t have earned income that exceeds half of his or her support. A child is considered to be a student if he or she attends school full-time for at least five months during the year.

How are the “Kiddie Tax” Rules Changing?

For 2018 through 2025, the Kiddie Tax rules have been revised to tax a portion of a child’s net unearned income at the rates paid by trusts and estates. These rates can be as high as 37% for ordinary income or, for long-term capital gains and qualified dividends, as high as 20%.

The trust and estate tax rate structure might look unfavorable because the rate brackets are compressed, compared to the brackets for single individuals. In other words, the Kiddie Tax rules can override the lower rates that would otherwise apply to an affected child’s unearned income, but the new rules’ simplicity might override this negative.

Under prior law, the Kiddie Tax rules taxed a portion of a child’s unearned income at the parent’s marginal tax rate if that rate was higher than the child’s rate. For 2017, the parent’s rate could be as high as 39.6% for ordinary income or, for long-term capital gains and dividends, as high as 20%. The Kiddie Tax has been a great strategy to save money in a child’s or grandchild’s name precisely because of their significant tax advantages. A portion of the money earned – the first $1,050 of the child’s investment income (including interest, dividends, and capital gains distributions) was tax-free; the next $1,050 was taxed at the child’s rate; and investment income above $2,100 was taxed at the parent’s or grandparent’s “marginal” tax rate, i.e., the highest rate applied to the last dollar earned.

The 2017 Tax Cuts and Jobs Act made an important change to the graduated Kiddie Tax rate structure. Instead of a child’s investment income above $2,100 being taxed at the parent or grandparent’s individual tax rate, it will now be taxed at the 2018 trust and estate tax rates:

Will Families Now Pay More or Less?

How much a family will now pay under the new tax regime will depend on the amount of investment income and the child’s own marginal tax bracket. The parent’s taxable income no longer impacts the child. Moderate unearned income for the child will generally result in lower taxes paid.

There is a wide array of educational savings plans available, including the popular 529 Education Plan available in most states. Consult your tax advisor to determine if establishing a 529 Education Plan on your child’s behalf will be beneficial in keeping the investment income off of your own tax return.

Speak with your Marcum tax adviser about how changes in the Kiddie Tax law may affect your family and the best alternatives for savings and investments.