The Kiddie Tax Explained

kiddie tax piggie bank.jpgIt’s that time of year! We are all thinking about taxes, but here’s a tax you may not have given much thought to: the Kiddie Tax. This is a tax that was imposed as a way to prevent high tax bracket parents from shifting income to their lower bracket children by placing investments in the child’s name, not the parent’s name (a practice that was once relatively common)–I know, I once came home from college, answered the phone, and my mother’s accountant actually said, by way of introduction, “you don’t know me, but I certainly know you!”
The kiddie tax currently falls on investment income (interest, dividends, capital gains and other unearned income, such as from a trust) earned by children that is over $2000 annually for children aged nineteen or younger (or 24 if the child is a full-time student). Once a child’s income reaches that threshold amount, it will be taxed at their parent’s highest tax rate. If your child is actually working and getting paid, that income will still be taxed at the child’s lower tax rate.

This is relevant to estate planning if you have established an annual gift trust for your children, since income from that trust falls within the definition of ‘unearned income.’ To minimze income taxes on such a trust, the Trustee could invest in assets that appreciate over time, but don’t generate much (if any) taxable income until they are sold (when your children will be older and taxed at their own tax rates).

Here are a few examples: tax exempt muni bonds or Treasury bills that mature after a child turns 24, growth stocks or growth mutual funds that do not pay dividends, index funds or other funds that are managed to generate little taxable income.