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Coping with the Kiddie Tax Expansion

Lawmakers originally imposed the “kiddie tax” in order to make it harder for high-income households to evade taxes. In recent years, Congress has expanded the so-called kiddie tax to make it more challenging for parents to transfer investment income to a child to take advantage of the child’s lower tax rate. New strategies must be sought by parents whose primary goal is to save for their child’s education.

In 2014, the first $1,000 of unearned income in the child’s name is tax free, while the next $1,000 of unearned income is taxed at the child’s tax rate. Any amounts above the $2,000 mark are then taxed at the parents’ marginal rate.

While the kiddie tax originally applied to children up to age 14, the cutoff limit rose to age 18 in 2006 and age 19 in 2008. In addition, starting in 2008, full-time college students under the age of 24 are also taxed at their parents’ rate on unearned income in excess of the exclusion amount, unless the student’s earned income is greater than one-half of his or her support.

The kiddie tax applies to non-wage, or unearned income, but not to income earned by the child through a part-time or full-time job. Unearned income is generally investment and capital gains income that includes interest, dividends, rents, profits on property sales, and certain types of royalties. Congress acted to tighten the rules on giving appreciated stocks and mutual funds to children, after it became apparent that some wealthier families intended to exploit the 0% rate on capital gains taxes in effect through 2010 by shifting a portion of their investments to their children, who would then be able to sell these assets tax-free.

The revised kiddie tax will have the biggest impact on families who saved for their child’s college education by placing money into custodial accounts, bonds, or other savings vehicles, at a time when tax-free education savings accounts were not yet widely available.

College planning

Parents can avoid being hit by the kiddie tax in the future by saving for their children’s education using a tax-advantaged savings account. While contributions to Coverdell Education Savings Accounts (ESAs) are made with after-tax dollars, earnings grow tax deferred, and withdrawals are tax free when used for qualified post-secondary education costs.

In some cases, parents may also wish to encourage their older children to take paid employment, which generates earned income that will be taxed at lower rates. College students, in particular, may be able to avoid the kiddie tax altogether by earning more than 50% of the amount needed to support themselves.

Parents who are business owners could also consider hiring their children to work as their employees, provided they compensate their children at no more than the market rate for the tasks they perform. This strategy provides the child with earned income, which is taxed at the child’s lower ordinary income tax rate.

Before taking this step, check to see if adding their income to your return will push you into a higher tax bracket. What happens if a child has both earned and unearned income? In this case, it may be necessary to file a return and pay taxes depending on the separate and total income levels involved. Consult IRS Publication 929 for more details, or contact your local CPA with questions.

For more information on how the kiddie tax may affect your tax situation, consult your tax professiona