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, did not do away with the kiddie tax; however, it simplified it and changed the tax rates children must pay on their unearned income.

Who Does the Kiddie Tax Apply To?

The kiddie tax only 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.

Moreover, 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) are not subject to the kiddie tax rules -- that income is taxed at the child's regular income tax rate.

The Kiddie Tax Before 2018 and After 2025

Under the old law in effect before 2018, children could pay tax at their own income tax rate on unearned income they received up to a threshold amount. All unearned income that kids received above the threshold amount was taxed at their parent's highest income tax rate, if higher than the child's rate. That rate could be as high as 39.6%, compared to the 10% rate that most children would be paying. Figuring the kiddie tax could be complex. For example, if a parent had more than one child subject to the kiddie tax, the net unearned income of all the children had to be combined, and a single kiddie tax calculated. The TCJA eliminated these rules starting in 2018, but they are to return for 2026 and later.

The Kiddie Tax 2018 through 2025

For 2018 through 2025 children's unearned income is not taxed at their parents income tax rates. Instead, all net unearned income over a threshold amount--$2,200 for 2019--is taxed using the brackets and rates for trusts and estates. The 2019 rates are shown in the following chart:

This greatly simplified the kiddie tax by applying a single set of tax rates to all of a child’s unearned income. Moreover, a child's tax rate is no longer affected by his or her parents’ tax situation or the unearned income of any siblings.

However, these rates can be higher than the parents’ rates which would have applied under prior law. 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. Thus, it is not advantageous to arrange your affairs so your dependent children have substantial amounts of unearned income.

On the other hand, children with smaller unearned incomes can pay less under these tax rates. For example, a child can have up to $4,800 in unearned income and pay only a 10% tax on $2,600 of it, for a $260 total tax ($4,800 unearned income - $2,200 kiddie tax floor = $2,600 income subject to kiddie tax; 10% x $2,600 = $260). Most parents pay income tax at a higher rate than 10% (married taxpayers would have to have a taxable income of $19,400 or less to pay tax at this rate).

It's important to monitor how much unearned income a child has during the year to make sure he or she avoids the high 35% or 37% brackets.

If your child has unearned income subject to the kiddie tax, he or she should file his or her own tax return with IRS Form 8615, Tax for Certain Children Who Have Unearned Income.