The Kiddie Tax

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By Roy Lewis
January 25, 2002

Kids with investment income don't escape the notice of the IRS. For them, there's the "kiddie tax." This so-called 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. (If you think "kiddie tax" is a silly term, you may prefer to use the full and proper name of the tax: "Tax for Children Under Age 14 Who Have Investment Income of More Than $1,500." What? You'd rather not? We didn't think so.)

For tax year 2001, the kiddie tax provisions work like this:

  • The first $750 in unearned income (such as 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 $750 and up to $1,500 is taxed at the child's rate (generally 15%, but usually much lower than the parents' rate).
  • Unearned income of more than $1,500 is taxed at an adjusted parents' rate. (Unless the child's rate is greater. This isn't likely, but it's 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 Dec. 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 tax on Form 8615, or the parents can report the child's income on their own tax return using Form 8814 ("Parents' Election To Report Child's Interest and Dividends"). But there are restrictions to reporting the child's income on the parents' return. Form 8814 can only be filed if:

  • The child's income is from interest and dividends only. (Capital gains from sales of stock would violate Form 8814.)
  • The child's gross income for the year is less than $7,000.
  • No prior-year estimated tax overpayments are applied to the child's current-year return.
  • 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 about how to file.

Deciding which filing option to use
This can be a difficult decision, since there's very little difference between options. Some advantages of filing the child's income on the parents' return:

  • Avoids the hassle of filing a separate return for the child.
  • The parents' net investment income may be increased, which may allow a larger investment interest deduction for the parent.
  • The adjusted gross income ceiling for charitable contributions is higher, which may allow for an increased deduction for charitable contributions.
  • The first $1,500 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.
  • If the child files his own return, he could be subject to the alternative minimum tax, but the AMT might not kick in when reporting on the parents' return.

But there are also disadvantages (of course):

  • The additional income, by increasing the parents' AGI, can reduce or eliminate the deductibility of some itemized deductions. These may include the medical expense deduction, the deduction for casualty and theft losses, and miscellaneous itemized deductions.
  • The additional income can reduce the $25,000 rental loss allowable for active participation. (If you own rental property, you probably already know this. If not, read IRS Publication 527.)
  • 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. This AGI increase might also trigger other conditions that are based on AGI, such as the taxability of Social Security benefits.
  • The additional income may reduce the earned income credit, the child tax credit, the dependent care credit, the Hope credit, the Lifetime Learning credit, and any other credits that are based on AGI.
  • The additional income may result in higher state tax liability for states that base their income taxes on federal AGI.

The tax rate for income above $1,500 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 were added to the parents' taxable income. This could put the child's income in a higher tax bracket than the parents'.

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.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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