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Understanding the Kiddie Tax: Tax Treatment Based on Income Thresholds

The kiddie tax is a US tax provision passed to discourage parents from giving their children unearned income to avoid paying higher tax rates. The Kiddie Tax’s age range and prerequisites are as follows:

Age Group: Children who fall under the age ranges listed below are subject to the Kiddie Tax:

  • 17 years old or younger at the conclusion of the tax year, as support obligations do not apply to those under the age of 18.
  • 18 years of age at the conclusion of the tax year, but only if their earned income is 50% or less of their “support.”
  • 19–23 years old if their earned income is less than or equal to half of their “support” and they are a full-time student.

According to the kiddie tax regulations, “support” covers items such as food, clothes, shelter, healthcare, and education. Whether a child’s unearned income is liable to be affected depends on the total amount of support provided by a parent for a child between the ages of 18 and 23. For children under 18, the support needs are irrelevant. The unearned income a child receives, such as interest, dividends, capital gains, rent, and royalties, is subject to the kiddie tax. Crucially, the kiddie tax is not applied to any wages or salaries (earned income) that the child receives. Three income thresholds—$0 to $1,250, $1,250 to $2,500, and $2,500 and above—are used to determine the tax treatment. We shall examine these thresholds and the corresponding tax treatment below. 

The kiddie tax does not apply to children who:

  • had no living parents as of the end of the tax year
  • were married and filed a joint tax return for the year
  • are not required to file a tax return for the tax year

Tax-Free Income for Children: Exploring the First Threshold of the Kiddie Tax

The first $1,150 of unearned income is covered by the kiddie tax’s standard deduction. This provision ensures that a portion of a child’s unearned income remains tax-free, providing some relief for children with minimal unearned income.

The standard deduction is a predetermined amount set forth by the Internal Revenue Service (IRS) that reduces the taxable income of individuals. For children subject to the kiddie tax, this standard deduction applies specifically to their unearned income, such as interest, dividends, and capital gains.

The standard deduction essentially shields the first $1,150 of a child’s unearned income from taxation in the context of the kiddie tax. Therefore, if a child’s unearned income is below this limit, they are exempt from paying federal income tax on that sum of money.

The presence of the standard deduction enables children to earn a minimal amount of money without having to pay taxes on it. It tries to promote children’s financial development without putting a heavy tax load on them while acknowledging that youngsters frequently have limited sources of income.

Kiddie Tax and Parental Income: How the Second Threshold Affects Tax Liability

The next $1,150 of unearned income, following the Kiddie Tax’s standard deduction, is subject to taxation at the child’s marginal tax rate. The marginal tax rate refers to the tax rate applied to the last dollar earned, reflecting the progressive nature of the U.S. tax system.

The idea of fairness in the US tax system is acknowledged by taxing this share of the child’s income at their marginal tax rate. The tax treatment is in line with the progressive nature of income taxes, where higher income levels are subject to higher tax rates, by using the child’s marginal tax rate.

The total income of the child, which includes both earned and unearned income, determines the marginal tax rate for that child. Earned income for the child, such as wages or salary, is taxed at ordinary income tax rates, just like for adults. However, the child’s marginal tax rate only applies to the percentage of their income that is unearned and falls inside this threshold.

It’s crucial to keep in mind that the marginal tax rate for the child may change depending on their overall income. With a rise in income, the child may enter a higher tax bracket, which would mean a higher marginal tax rate for every dollar earned.

Families may precisely calculate their tax responsibilities and make appropriate plans when they are aware of how the next $1,150 in unearned income will be taxed at the child’s marginal tax rate. It also emphasizes the significance of taking into account the total amount of income, including both earned and unearned income, in order to determine the proper tax treatment for each component.

Kiddie Tax Beyond $2,500: Navigating Tax Treatment for Higher Unearned Income

Anything exceeding $2,500 for 2023 (up from $2,300 for 2022) will be taxed at the parent’s rate rather than the child, who typically pays a lesser rate. The amount over $2,500 that a child receives in unearned income is taxed at the parent’s marginal tax rate. Because of this, the parent may owe more in taxes than they would have if the child’s income had been taxed separately because the child’s unearned income will be taxed at the same rate as the parent’s other income.

To deter parents from giving assets to their children with the intention of benefiting from their lower tax band, the extra unearned income is taxed at the parent’s marginal tax rate. The tax code tries to maintain equity in the allocation of tax liabilities and avoid income shifting techniques by applying the parent’s tax rate to the child’s income.

While this may result in a higher tax bill for the parents, it’s important to note that the kiddie tax rules are specifically designed to address potential tax avoidance scenarios. Taxing the child’s unearned income at the parent’s rate helps ensure that families cannot exploit lower tax brackets by shifting income to their children.

However, if the child’s unearned income falls below the threshold, it will be taxed at the child’s lower tax rate. This recognizes that children typically have limited income sources and allows for a more reasonable tax treatment based on their individual circumstances.

It’s worth mentioning that the parent’s other income, such as their earned income or income from investments, will continue to be taxed at their respective rates. Only the excess unearned income of the child above the threshold is subject to taxation at the parent’s rate.

Marginal Tax Rate 

A marginal tax rate is the percentage of tax applied to an additional dollar of income. It represents the rate at which the last earned dollar is taxed. Marginal tax rates are based on the progressive nature of income tax systems, where higher income levels are subject to higher tax rates. Understanding marginal tax rates helps individuals and businesses assess the impact of earning additional income and make informed financial decisions.

529 Plans 

A tax-advantaged savings plan called a 529 is created to encourage people to put money down for their children’s future educational costs. It takes its name from Internal Revenue Code Section 529, which outlines the details for these kinds of programs. The plan enables individuals, usually parents or guardians, to make financial contributions to an account set up for the purpose of covering eligible educational costs.

An important benefit of a 529 plan is that, as long as the withdrawals are used for approved school costs, the investment returns grow tax-free, meaning they are not subject to federal income tax. For accredited educational institutions, qualified expenses often include tuition, fees, books, supplies, and certain room and board charges.

Income from a 529 plan is usually exempt from the kiddie tax when it comes to taxes. Interest, dividends, and capital gains are examples of unearned income that is subject to the kiddie tax. The kiddie tax is not applied to withdrawals from a 529 plan that are spent for eligible school costs because they are classified as taxable and hence not unearned income.

This exception acknowledges the goal of 529 plans, which is to help families save money for college costs and give them a tax-advantaged vehicle to do so. It encourages families to use these plans to save and invest for educational reasons without being subject to additional tax penalties by removing income from a 529 plan from the Kiddie Tax. It’s crucial to remember that distributions from a 529 plan may be subject to income tax and a 10% penalty on the earnings component if they are utilized for non-qualified purposes.

For additional questions, don’t hesitate to reach out to our accounting professionals at Lear & Pannepacker.