Minors Taxed At Parents' Rates: The Kiddie Tax

Volume 6 Issue 2006

Children under 18 (14 before 2006) who have investment income above a threshold amount have to pay tax at their parents' rates. At one time, wealthy families could save a great deal of money by transferring investment assets to minor children. Tens of thousands of dollars in investment income produced by those assets would be taxed to the children at the lower rates that apply to individuals who have relatively little income. Congress decided to limit the tax benefit from shifting income to children, so we now have a law that says children under 18 who have more than a small amount of investment income have to pay tax at their parents' tax rate. Tax pros call this rule the kiddie tax.

The age limit for this tax used to be 14, but beginning in 2006 it is 18.

Income Threshold

You don't have to worry about this rule until your child has investment income greater than a threshold amount, which is two times the amount allowed as a standard deduction for a dependent who has only investment income. For 2006, that amount is $850, so the kiddie tax begins to apply when your child has more than $1,700 in investment income.

Your child can still owe regular income tax with less than $1,700 in income. This is merely the threshold amount of investment income for the special kiddie tax.

Age 18

The rule does not apply if your child reached age 18 by the end of the year. (Before 2006 the rule applied until age 14.) For purposes of this rule, a child born January 1 is considered age 18 on December 31 of the year preceding the 18th birthday. As a result, a child 18 or older gets the full benefit of the lower tax rates, even when investment income exceeds the threshold amount.

Married Filing Jointly

When Congress raised the age limit for the kiddie tax to 18 in 2006, they added a provision saying it won't apply if the child is married and filing a joint return.

How It Works

If your child has more than $1,700 in investment income, the tax is figured according to a special calculation. The first $1,700 of investment income is still taxed at the child's lower rates, but any additional investment income is taxed at the parents' rates.

Example: In 2006 your child has $2,700 of interest income and no other income. The first $850 of investment income escapes taxation: your child's standard deduction takes care of that. The next $850 is taxed at the child's rate of 10%. That leaves $1,000 to be taxed at whatever rate would apply if this income were added to the income reported on your tax return. Suppose you're in the 28% tax bracket. The tax on your child's income would be 10% of $850 plus 28% of $1,000, for a total of $365.

Even though the tax is calculated at the parents' rate, it is still the child that owes the tax not the parents.

How to Report

There are two ways to apply the parents' rate to the child's income.

One is to include the income on the parents' return. This option isn't always available, or you may decide it isn't best for you even if it is available.
The other way is to report the income on a return for the child but with a special calculation on IRS Form 8615 (click for form and instructions).

Additional guidance is available in IRS Publication 929, Tax Rules for Children and Dependents.