The “kiddie” tax is a tax that is imposed on a child’s investment and other unearned income. The tax was introduced in 1986 as part of the Tax Simplification Act of 1986. This column discusses what the “kiddie” tax is and how it has continued to frustrate investors and financial advisors over the past 30 years.
The History Behind the Kiddie Tax
Prior to the enactment of the “kiddie” tax, wealthy investors with young children attempted to legally reduce the tax on their investment income by shifting investment assets out of their name and into their children’s name. This was especially true with appreciating assets that could potentially generate capital gains such as stocks and stock mutual funds. In particular, the strategy was that a parent would transfer a capital asset – a stock, a bond, or a mutual fund – that was generating portfolio income and that expected to appreciate in value over the years. After transferring the asset into a child’s name, the parent would eventualy sell the appreciated asset, hoping to take advantage of the child’s lower tax bracket and end up paying little or no capital gains tax. Parents could accomplish this goal of transferring appreciated assets by gifting to a child $10,000 per year ($20,000 per year for both parents) under the Uniform Gift to Minor’s Act (UGMA) or the Uniform Transfer to Minor’s Act (UTMA).
But Congress changed the rules in 1986 with the passage of the Tax Simplification Act of 1986, making most “unearned” income received by a child younger than 14 as if it were the parent’s income and therefore taxed at the parent’s higher tax bracket. Thus was the start of the “kiddie” tax.The “kiddie” tax age limit was subsequently increased to age 18 in or to any age under 24 if the child is a full-time student.
Many parents and financial advisers are not completely familiar with the details of the “kiddie” tax law. It is important therefore to review the more intricate details and what they mean to affected parents as these parents prepare their 2017 tax returns.
Some financial advisers mistakenly associate the “kiddie” tax with income that is generated only from an investment portfolio; this includes interest, dividends and capital gain income. However, the tax actually applies to any income that is not considered “earned”. Besides interest, dividend and capital gains income, the following types of income meet the definition of “unearned” income:
- Social Security income;
- income from a trust; and
- payments from an inherited traditional IRA.
This means only a child’s salary, wage or tip income are exempt from the “kiddie” tax.The following examples illustrate:
Example 1. Marjorie, age 14, is receiving her deceased father’s Social Security as child Social Security survivor payments. These payments will continue until Marjorie becomes age 18. Marjorie’s monthly Social Security payments are included in the calculation of the “kiddie” tax.
Example 2. Marjorie’s father was a FERS employee when he died. As such, Marjorie is entitled to receive children survivor benefits from the Office of Personnel Management. However, Marjorie cannot receive both her father’s Social Security death benefit payment in Example 1 and the OPM benefit. She receives the higher of the two amounts. But when Marjorie becomes age 18, her Social Security death benefit payment will cease and, if Marjorie attends college or university on a full-time basis, she will qualify for the FERS children survivor benefits. The FERS children survivor benefits are also included in the calculation of the “kiddie” tax.
Example 3. Peter, age 19, is the recipient of a trust established by his late grandparents. All of the trust income paid out by the trust to Peter is included in the calculation of the “kiddie” tax.
Example 4. Cheryl, age 16, was designated as one of the beneficiaries of her grandmother’s traditional IRA. Cheryl’s parents elected to have Cheryl’s inherited IRA directly transferred to an “inherited” IRA in which Cheryl will receive each year a required minimum distribution (RMD) from the IRA custodian. Each year the RMD will be included in income for the purpose of calculating the “kiddie” tax.
Example 5. Same facts as Example 4 except that Cheryl inherited a Roth IRA from her grandmother, not a traditional IRA. Assuming that Cheryl’s grandmother met all the rules for making a qualified Roth IRA withdrawal, Cheryl’s RMD from the inherited Roth IRA will not be included in income and therefore is not used in the calculation of the “kiddie” tax.
The good news with respect to the “kiddie” tax is that children are allowed for 2017 an exemption of $1,050, plus another $1,050 that is taxed at their own tax rate; most probably at the 10 or 15 percent tax rate. Both of these amounts are subject to inflation adjustments which mean that for tax year 2017 any unearned income over $2,100 is subject to the “kiddie” tax.
Calculating the Kiddie Tax
Calculating the “kiddie” tax is far from simple. It is not as simple a task as just applying the parent’s tax bracket to the child’s income. Instead, the total unearned income over $2,100, during 2017, is added to the parent’s other income and the parent’s total tax is recalculated. The increase in the total tax is then attributed to the child’s unearned income and is payable by them.
The “kiddie” tax is calculated as part of the child’s tax liability (or children’s tax liabilities if there are multiple children subject to the “kiddie” tax) on IRS Form 8615. For some children, the child’s unearned income can be reported on part of the parent’s tax return using IRS Form 8814. However, in so doing, this could lead to a higher tax for the parents rather than including the income on the child’s return and filing for the child on their own.
In short, the purpose behind having the “kiddie” tax is to prevent parents from transferring their investment income to their children and reducing the parents’ tax liability on their investment income. The “kiddie” tax does a very good job in accomplishing that. Parents should therefore be fully aware of the “kiddie” tax and its effect on income producing portfolios that parents may gift to their children.
Another downside of gifting a parent’s portfolio to a child is that it will lessen a child’s chances for qualifying for financial aid at a college or university. This is because the financial assets held in a child’s name are counted far greater against the child for financial aid purposes than financial assets held in the parent’s name.