Despite its name, the “kiddie tax” is not limited to toddlers or preschool children. In fact, it may continue to apply to 20-somethings. Saving grace: At least you may be able to minimize or even eliminate this additional tax.
Basic rules: Generally, income is taxed at the tax rate of the individual who receives it. For example, if you are in the top 39.6% tax bracket, your top dollars are taxed at the 39.6% rate. On the other hand, if your child is in the 10% bracket, the child pays tax at a maximum rate of only 10%.
However, a special rule applies to certain children who receive unearned income above an annual threshold. In this case, the excess is taxed at the top tax rate of the child’s parents. Thus, instead of being taxed at the 10% rate, your child may be taxed at the 39.6% rate on the excess.
The annual threshold is adjusted for inflation, but recent increases have been small or nonexistent. For 2016, the threshold is $2,100 (the same as it is on 2015 returns).
Initially, the kiddie tax applied only to children under age 14, but the limit has been raised several times. The current age limit is 19, or age 24 for a full-time student if the child does not have earned income in excess of half of his or her annual support. In other words, if your dependent child is in college, the kiddie tax likely still applies. However, here are four possible ways to reduce the tax liability.
- Keep your child’s unearned income below or near the $2,100 threshold. For instance, you might wait until next year to give your child income-producing property. This technique works especially well if you do not expect your child to pay the kiddie tax in 2017.
- Utilize tax-deferred investments that do not produce current income. This may include investments in growth stocks and U.S. savings bonds. Similarly, if the child buys certificates of deposit or Treasury bills that will not mature until next year, you can avoid or minimize the kiddie tax this year.
- Allocate a portion of your child’s investment portfolio to municipal bonds (“munis”) or muni bond funds. Generally, the income received from these investments is completely free of federal income tax, so your child can pocket any amount without kiddie tax worries.
- Hire your child to work for your company. Because the wages constitute earned income, this will not trigger any kiddie tax complications. As long as the child is paid a reasonable salary for the services performed, your company can deduct the wages. This is a good way to help a child save money for college without adverse tax consequences.
Tax return option: If your child owes the kiddie tax for 2015, you may elect to have the extra income reported on your 2015 return as long as certain conditions are met. More details from your tax return preparer are available upon request.