The Kiddie Tax
Income shifting to kids and other family members is a popular tax strategy but there are limits.
One of the best ways to lower your taxes is to lower your tax rate. One way to do this is to shift income to your children, so they can pay tax on it at their tax rates, which are ordinarily much lower than yours. Due to changes in the tax laws, this strategy is not as useful as it used to be, but it still has its place for high-income taxpayers with dependent children.
The simplest way to shift income is to give income-producing property to your lower-tax bracket children (or other relatives or nonrelatives with whom you want to share your income). A gift is not taxable income to the recipient, so your child need not pay any tax on its value. Since the child now owns the property, he or she will pay tax on any income it generates at the child’s own (lower) tax rates.
Income-producing property (or investment property) is property that generates investment income—interest, dividends, and profits from asset sales. Such investment income is also called “unearned income” because it is obtained without working at a job or business. Investment property includes:
- mutual funds, and
- real estate.
Example: Ed and Edna have $20,000 in a savings account that generates $1,000 in interest each year that they must pay tax on at their top 28% income tax rate. They give the money to their daughter, Edwina. She now reports the interest income on her own tax return and pays tax on it at her own tax rate. Because her total unearned income for the year is $1,000, she pays no taxes at all. This saves $280 in tax that Ed and Edna would have had to pay on the interest if they reported it on their own tax return. Edwina can use the money to pay for her college education.
It might seem that wealthy people could save a fortune in taxes by transferring substantial income-producing property to their children. However, this is not the case because special "Kiddie tax" rules adopted a few years ago greatly limit the tax savings you can achieve through this strategy.
Under the kiddie tax, children pay tax at their own income tax rate on unearned income they receive up to a threshold amount ($2,100 in 2016 and 2015). That part is fine, here's the hitch: All unearned income kids receive above the threshold is taxed at their parent's highest income tax rate, which can be as high as 35%. Any unearned income below the standard deduction amount ($1,050) is not taxed or reported to the IRS.
Thus, these rules establish three stages of taxes on investment income for children subject to the kiddie tax:
- Investment income $0 to $1,050 is tax free.
- Investment income of $1,051 to $2,100 is taxed at the child’s tax rate.
- Investment income over $2,100 is added to the parent’s taxable income and taxed at the parent’s top income tax rate.
- under age 18 at the end of the year
- age 18 at the end of the year and whose earned income does not exceed half of the annual expenses for the child's support, or
- a full-time student over age 18 and under age 24 at the end of the year and and whose earned income does not exceed half of the annual expenses for the child's support.
Obviously, you don’t want your child under 18 to have more than $2,100 in unearned income during the year. But that is not a negligible amount. For example, a child whose investments earn 5% per year could have a total of $38,000 in cash or property and be within the $2,100 limit each year. Moreover, the child would only pay $105 in income tax on the $2,000 in income—no tax is due on the first $1,050 because of the standard deduction and only a 10% tax is paid on the remaining $1,050. In contrast, if you kept that $38,000, you would have to pay taxes on the $2,000 profit at your own income tax rates. If, for example, your top rate was 28%, this would come to $536.
The kiddie tax applies only to unearned income a child receives from income-producing property. All salary or wages a child earns through full or part-time employment is taxed at the child's tax rate. There is no kiddie tax for children 24 years old and over, even if they are their parents' dependents. Nor does the tax apply to children 19 to 23 who are not full-time students or provide more than half of their support from their earned income.