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January 29, 1999
The Kiddie Tax
By Roy Lewis (TMF Taxes)
The so-called "kiddie tax" is not really a specific tax at all. Instead, it refers to the limitations the IRS places on the ability of a child under the age of 14 to have unearned income taxed at the child's lower tax rate.
For tax year 1998, the "kiddie tax" provisions work like this:
-- The first $700 in unearned income (i.e., interest, dividends, capital gains, etc.) is not subject to tax, either at the child's rate or the parents' rate.
-- Unearned income of more than $700 and up to $1,400 is taxed at the child's rate (generally 15%, but usually much lower than the parents' rate).
-- Unearned income of more than $1,400 is taxed at an adjusted parents' rate (unless the child's rate is greater... not likely, but possible).
The "kiddie tax" rules DO NOT apply if:
-- The child is under age 14 and neither parent is alive at the end of the taxable year; or
-- The child is age 14 or over as of December 31 of the taxable year.
Filing the Tax
There are two ways to file and pay the "kiddie tax." The child can file her own return and compute the "kiddie tax" on Form 8615, or the parents can report the child's income on their own tax return using Form 8814. But there are restrictions to reporting the child's income on the parents' tax return. Form 8814 can only be filed if:
1. The child's income is from interest and dividends ONLY.
2. The child's gross income for the year is less than $7,000.
3. No prior-year estimated tax overpayments are applied to the child's current year return, and
4. No estimated tax or withholding tax has been paid in the child's name.
So be sure to keep these restrictions in mind when making your decision how to file.
Before the Small Business Protection Act passed in August of 1996, the best method was almost always: "File the child's return alone, using Form 8615." But the 1996 Tax Act corrected the quirk in the law that provided a greater benefit for the child filing an individual return. Now that the parent and child are back on a more level playing field, you must determine the method that will be most appropriate for your situation.
Some advantages of filing the child's income on the parents' return:
1. Avoiding the hassle of filing a separate return for the child.
2. The parents' net investment income may be increased, which may allow a larger investment interest deduction for the parent.
3. The Adjusted Gross Income (AGI) ceiling for charitable contributions is higher, which may allow for an increased deduction for charitable contributions.
4. The first $1,400 of the child's income is taxed on Form 8814 and is not included in the parents' taxable income. This may reduce state tax liability in states that base income tax on the federal taxable income.
5. If the child files his own return, he could be subject to the Alternative Minimum Tax (AMT), but the AMT might not kick in when reporting on the parents' return.
But there are disadvantages to reporting the child's income on the parents' tax return:
1. The additional income can accelerate the phase-out of itemized deductions due to AGI limitations. Such deductions might include the medical expense deduction, the deduction for casualty and theft losses, and miscellaneous itemized deductions.
2. The additional income can reduce the $25,000 rental loss allowable for active participation.
3. Because of the increase in the parents' AGI, the deduction for an IRA contribution may be phased out or eliminated. It's even possible that the additional income could prohibit a conversion from a regular IRA to a Roth IRA. And this increase in the parents' AGI might also trigger other issues that are based on AGI, such as the taxability of Social Security Benefits.
4. The additional income may reduce the earned income credit, the child tax credit, the dependent care credit, the Hope credit, the Lifetime Learning credit, or any other credits that are based on AGI.
5. The additional income may result in higher state tax liability for states that base their income taxes on federal AGI.
How to Beat the System
First, if at all possible, keep the reported unearned income below $700 for each child until they reach age 14. Barring that, at least keep the income below $1,400 to avoid paying tax on the unearned income at the parents' adjusted tax rate (more on that rate later).
How do you do this?
1. Series EE Savings Bonds are a good technique. Certainly not very Foolish, but you can elect that the interest on the bonds not be recognized until sometime after the child reaches age 14.
2. Invest in growth stocks that don't pay dividends and that you won't sell until after the child reaches age 14.
3. Watch out with mutual funds. They are required to pay out dividends and capital gains on an annual basis resulting in... oops� unearned income. Instead of mutual funds, you might want to build a stock portfolio for your child.
4. And for goodness sake, don't invest in double tax-free municipal bonds or municipal bond funds until the taxable earned income is greater than $1,400 per year.
The Tax Rate for Income Above $1,400 Per Year
The tax rate used in computing the "kiddie tax" is the rate that would apply to the parents if the child's net unearned income was added to the parents' taxable income. This could put the child's income in a higher tax bracket than the parents.
The Multiple Children Problem
Having two or more children confuses the issue. The tax rate for the children is now computed by adding the net unearned income of all under-14 children to the parents' taxable income. The resulting tax is allocated among the children based on their share of income.
The "kiddie tax," while a valuable part of your tax strategy, can lead to some confusion. Keeping the above tips in mind while planning your child's investments will make this planning easier. Also helpful to the planning process is IRS Publication 929, "Tax Rules for Children and Dependents." To receive this publication, call 1-800-TAX-FORM and request it, or download the document from the IRS website: http://www.irs.ustreas.gov. And, as always, if you have any specific questions on the "kiddie tax" issues, you can always post 'em in the Tax Strategies