What is Kiddie Tax?
The Kiddie Tax is a tax policy in the United States aimed at preventing parents or guardians from shifting their investment income to their children to benefit from the child’s lower tax rate. Specifically, net unearned income (e.g., interest, dividends, and capital gains) of children under a certain age threshold is taxed at the custodial parents’ highest marginal tax rate rather than the child’s potentially lower rate.
Mechanism of Kiddie Tax
Initially enacted by the Tax Reform Act of 1986, this regulation targets children under age 14. However, legislative changes in recent years have adjusted the ages involved. As of 2021, the Kiddie Tax affects children under age 19, or under age 24 if they are full-time students.
Key Features:
- Net Unearned Income: The income subject to Kiddie Tax primarily includes investment income such as interest, dividends, and capital gains.
- Threshold: In 2010, the threshold for net unearned income was $1,900. This threshold is subject to annual indexing for inflation.
- Rate: The net unearned income exceeding the threshold is taxed at the parent’s highest marginal tax rate.
Historical Context
The original intent behind Kiddie Tax was to curb tax avoidance through income shifting. Parents could theoretically divert income-generating assets to their children to benefit from their lower tax brackets. Kiddie Tax ensures that such shifted income is still taxed at the appropriate rates.
Recent Developments
Recent tax laws, such as those introduced by the Tax Cuts and Jobs Act of 2017, have modified the Kiddie Tax application. Primarily, it altered the taxable rate from being tied to the parent’s tax rate to the typically higher tax rates applied to trusts and estates.
Examples of Kiddie Tax
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Case of Unearned Income from Investments:
- Jane, aged 16, earns $2,400 in unearned income from dividends.
- The first $1,000 is not taxed.
- The subsequent $1,000 is taxed at Jane’s rate.
- The remaining $400 is taxed at her parents’ highest marginal rate.
-
Full-time Student:
- Joe, a 22-year-old full-time student, earns $4,000 through interest.
- His parents are in the 35% tax bracket.
- After accounting for the threshold and applicable deductions, the excess amount is taxed at 35%.
Frequently Asked Questions
Who is Subject to the Kiddie Tax?
Children under the age of 19 or full-time students under the age of 24 who have unearned income exceeding a specified threshold are subject to the Kiddie Tax.
How is the Threshold Amount Determined?
The threshold amount for unearned income is subject to annual inflation adjustments. The amount can be checked in IRS publications for the specific tax year.
What Types of Income are Considered Unearned Income?
Unearned income includes interest, dividends, capital gains, and other investment earnings.
Can Earned Income be Subject to Kiddie Tax?
No, earned income from wages, salaries, and other employment is not subject to the Kiddie Tax.
Related Terms
- Marginal Tax Rate: The percentage of tax applied to an individual’s last segment of income.
- Unearned Income: Income derived from investments and other sources not related to employment.
- Trust Tax Rates: Tax rates applicable to trusts and estates.
- Tax Reform Act of 1986: Legislation that significantly revised the federal tax code, including introducing the Kiddie Tax.
Online Resources
- Internal Revenue Service (IRS) - Kiddie Tax
- Investopedia - Kiddie Tax
- Tax Foundation - Kiddie Tax Overview
Suggested Books
- “The Everything Personal Finance in Your 20s and 30s Book” by Howard Davidoff
- “J.K. Lasser’s Your Income Tax (2021)” by J.K. Lasser Institute
- “Taxes Made Simple: Income Taxes Explained in 100 Pages or Less” by Mike Piper
Fundamentals of Kiddie Tax: Taxation Basics Quiz
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