11/20/2013 04:54 pm ET Updated Jan 25, 2014

Understanding the 'Kiddie Tax'

For something whose nickname sounds so innocent, the "kiddie tax" certainly can wreak havoc on unprepared taxpayers' yearly returns.

Congress first introduced the kiddie tax as part of the Tax Reform Act of 1986 to discourage wealthy parents from sheltering their investment income in accounts under their children's names, thereby avoiding paying taxes on the amounts. The rules have been tweaked periodically ever since.

Although the kiddie tax once applied only to the unearned income of children under age 14 (hence the nickname), it now impacts all children under age 19 (as well as full-time students under 24), provided their earned income does not exceed half of the annual expenses for their support.

Moreover, the kiddie tax is not just a wealthy person's problem: Any outright gifts parents or grandparents bestow on young children, whether to avoid triggering the gift tax or simply out of generosity, could actually generate investment earnings that would be subject to the kiddie tax if they exceed a threshold amount.

Here's a primer on how the kiddie tax works and whom it impacts:

As it does with adults, the IRS differentiates between income children earn (paper routes, summer jobs, etc.) and unearned investment income they receive such as interest, dividends and capital gains -- usually by way of accounts opened in their names by parents.

Taxation of the first $1,000 of a child's unearned income is generally offset by the $1,000 standard tax deduction for dependents and thus won't be taxed; the next $1,000 is taxed at the child's own income-tax rate (e.g., it's 10 percent for taxable income up to $8,925). However, all unearned income over $2,000 is taxed at the parent's marginal tax rate, which can be as high as 39.6 percent for married couples with taxable income over $450,000.

There are two ways to report your child's investment income to the IRS: File a separate return for your child using IRS Form 8615; or include it on your own tax return, using IRS Form 8814 -- the latter only works if they had no earned income to report. The tax owed will be the same either way.

Important note: Although including your children's investment income on your return may be more convenient, doing so could increase your adjusted gross income so much that you become subject to the alternative minimum tax or ineligible for certain income-based deductions and credits. For example, eligibility for the American Opportunity Tax Credit begins phasing out for individuals whose modified adjusted gross income exceeds $80,000 ($160,000 for married couples). When in doubt, calculate both ways or ask your tax professional for advice.

Other kiddie tax rules:
  • To be considered a full-time student, the child must attend school full time during at least five months of the year.
  • The kiddie tax does not apply to children who: are 19 to 23 and not full-time students; provide more than half of their own support from earned income; are over 24 and still dependents of their parents; or under 24 but married and file a joint tax return. These children are all taxed as adults at their own tax rate.

Remember, gifts themselves are never taxable to the recipient. If a gift generates unearned investment income, however, that's when taxation comes into play. Also, any gifts over $14,000 per individual, per year, will trigger the gift tax -- although most of us will never come close to reaching the $5.25 million lifetime gift exemption.

One strategy for passing along wealth to children impacted by the kiddie tax is to give them investments that appreciate in value over time, but don't generate much or any taxable income until they're sold -- ideally after the children are no longer eligible for the kiddie tax. For example:
  • Purchase U.S. savings bonds in their names and defer interest payments until after the age restriction has passed -- interest would then be taxed at their rate.
  • Buy municipal bonds that don't mature until your child is no longer subject to the kiddie tax. You won't owe tax on interest earned because municipal bonds are exempt from federal income tax. If the bonds are ultimately sold at a profit, they'll be taxed at the child's capital gains tax rate.
  • Buy them growth stocks or mutual funds for companies that reinvest profits for future growth, rather than paying out taxable dividends.

You can find more details on tax filing requirements for children in IRS Publication 929, "Tax Rules for Children and Dependents."

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.