Tax Planning - The Kiddie Tax and How You Can Avoid It

The federal tax law imposes a kiddie tax on children’s investment income (i.e., unearned income greater than $2,100 for 2015), and the income is taxed at the parents’ highest tax rate instead of the child's tax rate. However, there are some ways to minimize the tax.

Congress created the kiddie tax to discourage the use of the popular tax strategy designed to reduce a family’s overall income tax liability: shifting of investment income from the higher-bracket parents to the lower-bracket children.

How the Kiddie Tax Works

The kiddie tax applies when the child has at least one living parent at the close of the tax year, the child is not married and falls in one of these categories: the child is under age of 18, the child is under 19, or a full-time student under age of 23, and the child’s earned income does not exceed one-half of his/her support.  The child’s unearned income is first reduced by a $1,050 standard deduction, and next $1,050 is taxed at the child’s rate. The remainder is taxed at the parents’ rate.

Ways to Minimize the Kiddie Tax

Two ideas to minimize the tax are to either buy U.S. savings bonds and elect to defer tax on the interest until the child is no longer subject to the kiddie tax; or consider gifting growth-oriented securities to your children. Growth stock typically does not yield high income, and the stock tends to grow in capital value. Also, consider buying a permanent life insurance that provides a cash value, which will accumulate tax-free. If a child is a beneficiary of a trust, avoid kiddie tax by not distributing capital gains to the child. In addition, transfer money to qualified tuition plans such as 529 Plans or Coverdell Education Savings Accounts.

Another possible alternative is to plan for the child to provide for at least one-half of his or her support. If a child is working while attending college, college costs are by far the largest part of his/her support.  Also, scholarships are not considered support; therefore, increasing the amount of a child’s scholarships to cover his college expenses may allow the child to meet his or her own support test.

A child subject to the kiddie tax may also face an alternative minimum tax (AMT) liability.  Therefore, careful tax planning is imperative in order to achieve intended tax results and to address the complexity of the kiddie tax.

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