For a long time, a popular tax-saving strategy for high-income families was to funnel unearned income through their children to reduce their overall taxes. The IRS has never been thrilled with this practice, and adopted the "kiddie" tax in the 1980s to limit its effectiveness by taxing certain amounts of children's unearned income at a very high rate.
In recent years, the IRS has expanded the kiddie tax so that it's applicable to the unearned income of much older children (it used to apply to children under 14 -- now it applies to children under 19 or even older, if your child is in school). If you are a high-income family with children, it pays to learn about the kiddie tax and how you can make smart investments to avoid it.
What Is the Kiddie Tax?
Under the kiddie tax, children pay tax at their own income tax rate on unearned income they receive up to a threshold amount ($2,000 in 2013; up from $1,900 in 2012). That part is fine -- here's the hitch: All unearned income kids receive above the threshold amount is taxed at their parent's highest income tax rate. That rate could be as high as 35%, compared to the 10% rate that most children would be paying. Any unearned income below the standard deduction amount ($1,000 in 2013; $950 in 2012) is not taxed or reported to the IRS.
The net effect is that you get the benefit of the child's lower tax rate only for unearned income over the standard deduction amount ($1,000 in 2013) and below the threshold amount ($2,000 in 2013). Everything else above the threshold amount is taxed at the parent's highest rate.
The kiddie tax applies only to unearned income a child receives from income-producing property (or investment property), such as cash, stocks, bonds, mutual funds, and real estate. Any salary or wages that a child earns through full- or part-time employment are not subject to the kiddie tax rules -- that income is taxed at the child's tax rate.
The kiddie tax applies to:
children under 19 years of age, and
children aged 19 through 23 who are full-time students and whose earned income does not exceed half of the annual expenses for their support.
A child who turns 20 (or 24) by the end of the tax year is not subject to the kiddie tax. To be considered a student, a child must attend school full time during at least five months of the year. It doesn't matter whether the child is claimed as a dependent on the parent's return. However, the tax does not apply to a child under 24 who is married and files a joint tax return.
How to Stay Within the Kiddie Tax Limit
Obviously, you don't want a child subject to the kiddie tax to have investment income over the kiddie tax threshold amount. Luckily, this is a fairly high threshold. For example, a child whose investments earn 5% per year would have to have over $36,000 in cash or property to earn $1,900.
Also, there is no kiddie tax for children age 19 to 23 who are not full-time students or who provide more than half of their own support from their earned income or for children 24 years old and over, even if they are their parents' dependents. These children are taxed like adults -- all their income is taxed at their own income tax rates. If the kiddie tax doesn't apply to your children, you can give them all the money or property you want and their unearned income will be taxed at their individual rates, which will most likely be lower than yours.
But if your children fall within the kiddie tax rules, there is another way to stay within the limit -- give your child investments that appreciate in value over time but don't generate much or any taxable income until they're sold. If you wait until after the child turns 24 to sell, there's no need to worry about the kiddie tax.
Here are some ideas for these kinds of investments:
U.S. savings bonds. You could purchase U.S. savings bonds for your child and defer the payment of interest until the child is no longer subject to the kiddie tax. All the interest would then be taxed at the child's tax rate.
Municipal bonds. You could buy a muni bond for your child that matures after your child is no longer subject to the kiddie tax. You won't owe federal tax on the interest the bond earns while your child is younger (and subject to the kiddie tax) because muni bonds are exempt from federal income tax. If the muni bond is ultimately sold at a profit, it would be taxed as a capital gain at the child's capital gains tax rate, provided you waited until the child was no longer subject to the kiddie tax.
Growth stocks or growth mutual funds. You can give your child stocks, or funds made up of stocks, from companies that reinvest their profits for future growth rather than paying them to shareholders as taxable dividends. You could then wait until after the child ceases to be subject to the kiddie tax to sell -- for example, the year the child graduates from (or drops out of) college or turns 24, and the profit will be taxed at the child's capital gains rate.
Index funds. You could also look into buying funds whose investments mirror a stock index or some other criteria and are likely to generate minimal taxable annual income.
Tax-managed mutual funds. These funds are specifically designed to generate little taxable income. Again, you could sell them after the child ceases to be subject to the kiddie tax.
Treasury bills. If your child is almost at the age when he or she will not be subject to the kiddie tax, buy a Treasury bill that won't mature until the no-kiddie-tax year. That way, the child won't earn any interest while the kiddie tax still applies.
To learn more about investment strategies when you have children, as well as other ways to lower your taxes, get Easy Ways to Lower Your Taxes, by Stephen Fishman (Nolo).