The Expanded Kiddie Tax and How to Offset It

For taxpayers with children under the age of 14, the Kiddie Tax was implemented in 1986 to insure that higher tax-bracketed parents did not transfer their investments to their children to avoid or minimize their own income taxes.  This is not a Child Tax Credit, but a tax incurred at a lower rate for the earnings of minor children.

In 2006, the Kiddie Tax was expanded to include children under the age of 18.
Anyone under the age of 18 earning more than $1,700 of income would be taxed at the parents rate.  As of 2008, the Kiddie Tax now includes children under the age of 19 or children up to the age of 23 who are full-time students and are dependents.  The earnings threshold before being taxed at the parents rate is $1,900.  Remember that parents, provided they meet the income threshold levels, can still claim both Child Tax Credits and Child Care Credits provided the qualifying dependents meet the guidelines outlined by the IRS.  Remember that the maximum age for qualifying children under the Child Tax Credit guidelines is 17.

Keep in mind however, that the Kiddie Tax applies to unearned income.  This includes earnings on investments, capital gains & dividends ? it does not include ‘earned’ income from paychecks from a full or part-time job.

To minimize the tax impact, past practices included investments in low current income such as low-dividend stocks or Treasury Bonds.  Additionally, this helps parents to insure that children are not earning more than half of their support, disqualifying them for other Child Tax Credits.

Specifically affected are those accounts identified in the Uniform Gift to Minors Act (UGMA) and the Uniform Transfer to Minors Act (UTMA).  In the past, assets could be placed in accounts for the benefit of minor children but the control of the accounts would remain with the parent or guardian until the child reached the age of majority, typically at the age of 18-21 years. With current tax laws, income from these accounts can be taxed at the trustee’s rate once the income reaches $1,900.  Thank you Uncle Sam for the Child Tax Credit ? we need it to offset the cost of the modifications to the Kiddie Tax!

The assets in these accounts would have to be liquidated to be eligible for transfer to a 529 College Plan.  Additionally, the 529 College Plan is not specific to one child and would need to be set up for distribution should there be more than one child with assets liquidated and transferred to the account.

The sale of assets in these accounts would still be subject to capital gains but the rate is less than that of parents (5% vs. 10-15%).  Not a Child Tax Credit, but definitely a break over the tax rates for parents.

Even selling after the child reaches the age of majority, provided they are in college, may still yield a lower capital gains rate than that of their parents.

Yet another item for consideration is that children aged 18-23 are not subject to the extra tax provided their earned income exceeds more than ½ of their total support.

For more information on the Kiddie Tax and Child Tax Credits, talk to your tax professional or consult the IRS.

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