The Kiddie Tax: Limits on Shifting Unearned Income to Children

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.

The Tax Cuts and Jobs Act (TCJA), the massive tax reform law that took effect in 2018, made major changes in the kiddie tax that were in effect for 2018 and 2019. However, these proved so unpopular they were repealed in 2019.

Who Does the Kiddie Tax Apply To?

The kiddie tax only applies to:

• children under age 18 at the end of the tax year,
• children age 19 at the end of the tax year who don't provide more than half their own support with earned income, and
• children under age 24 at the end of the tax year who are full-time students and whose earned income does not exceed half of the annual expenses for their support.

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.

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 (or self-employment) aren't subject to the kiddie tax rules—that income is taxed at the child's regular income tax rate.

If your child's interest and dividend income (including capital gain distributions) was more than $1,250 and less than $12,500 (2023), you can elect to include that income on your (parents') return rather than file a return for the child. In this event, all the income is taxed at your tax rates—you could end up paying more with this method.

Otherwise, a child with more than $2,500 in unearned income in 2023 must file their own tax return with IRS Form 8615, Tax for Certain Children Who Have Unearned Income. Also, children who earn more than the standard deduction—$13,850 in 2023—from both earned and unearned income must file their own tax return.

The Kiddie Tax for 2020 and Later

The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) repealed the changes made by the TCJA in the kiddie tax. The SECURE Act reinstated the kiddie tax as it was before 2018. This change is mandatory for 2020 and later. Under these rules, the Kiddie tax works like this:

• the first $1,250 (2023) of unearned income is covered by the kiddie tax's standard deduction and isn't taxed
• the next $1,250 (2023) is taxed at the child's tax rate, and
• all amounts over $2,500 (2023) are taxed at the parents' tax rate—that rate can be as high as 37%, as shown in the chart below, compared to the 10% rate that most children would be paying.

In some cases, figuring out the kiddie tax can be complex. For example, if a parent has more than one child subject to the kiddie tax, the net unearned income of all the children has to be combined, and a single kiddie tax calculated.

The Kiddie Tax for 2018 and 2019

For 2018 and 2019, parents had the choice of calculating their kiddie tax using their personal income tax rates or using the method prescribed by the TCJA. This method used the tax rates for trusts and estates instead of parent's personal rates. However, these rates can be higher than the parents' rates.

For example, the kiddie tax rate is 37% on income over $12,750. A married couple would have to have over $612,350 in income in 2019 to pay tax at this rate. On the other hand, children with smaller unearned incomes can pay less under these tax rates.

If you paid kiddie taxes for 2019 using the estates and trusts tax rates, you can recalculate them using your personal rates under the current rules. If this results in lower taxes, you were owed a refund. You may still have time to claim it by filing an amended return using IRS Form. You must amend your tax return within three years after the time you filed it, plus extensions. If you filed on April 15, 2020, or earlier, the time to amend has expired. But, if you obtained an extension to file, you may have until October 15, 2023, to amend your return and claim your refund.

Unfortunately, if you also paid kiddie taxes for 2018 using the estates and trusts tax rates, you can do nothing because the period to amend your 2018 tax return has expired.