Kiddie Tax Rules in 2013

By Remy Schneider, Tax Manager

The Kiddie Tax, as parents may know, is a tax on a dependent child’s investment income at the parent’s top marginal tax rate. The Kiddie Tax was designed to prevent parents from lessening their overall tax liability by shifting some of their income to their children who are in a lower tax bracket. The Kiddie Tax, however, does not distinguish between tax savvy parents attempting to shift income and those who are simply trying to give their children an opportunity to learn about money management from an early age. This article will provide a brief overview of how the Kiddie Tax rules operate in 2013 as well as suggest ways to avoid the tax.

The Kiddie Tax rules will apply, rendering a portion of the child’s investment income subject to tax at his or her parent’s 2013 marginal tax rate, if all of the following are true:

  1. The child has investment income over $2,000;
  2. The child meets one of the following age requirements:
    1. The child was under 18 at the end of the year;
    2. The child was 18 at the end of the year and the child’s earned (i.e., wages) income was not more than half of his or her support for the year; or
    3. The child was between the ages of 19 and 23 at the end of the year, a full-time student, and his or her earned income was not more than half of his or her support.
  3. The child is required to file a tax return for the year;
  4. The child does not file a joint tax return for the year; and
  5. At least one of the child’s parents was alive at the end of the year.

Kiddie Tax rules should be kept in mind when parents and grandparents are contemplating gifting to children and grandchildren. Investment income includes portfolio income such as interest, dividends, and capital gains, as well as social security, pension benefits, and distributions from most trusts. Gifts of portfolio income or of property that produces portfolio income, such as stocks, could potentially trigger the Kiddie Tax.

How can parents avoid the Kiddie Tax? One option is to purchase investments that generate little or no taxable income until they are sold, ideally after the child attains age 24 and the Kiddie Tax no longer applies. Certain U.S. Savings Bonds, for example, allow you to defer reporting taxable income from the bonds until they are sold. Municipal bonds are federally tax-exempt and any gain from the sale of the bonds could be postponed by holding onto them until the child turns 24. Treasury bills that mature after the child turns 24 will not earn any interest while the Kiddie Tax still applies. Certain “growth” stocks and mutual funds from companies that reinvest dividends instead of paying them out to shareholders are another option.

A 529 plan is another good investment for college-bound children. Parents can make plan contributions without worrying that they may be creating a tax liability for the child because 529 account earnings are tax-deferred. Moreover, if the funds are used to pay for qualified education expenses, distributions from the plan are tax-free.

Lastly, if the child is between the ages of 19 and 24, is a full-time student (for at least 5 months of the year), and works enough to provide more than half of his or her own support, the child will escape the Kiddie Tax and pay tax at his or her own tax rate. This may present a planning opportunity for parents who own their own business and legitimately employ their child. In addition to avoiding the Kiddie Tax, wages paid to the employee-child reduce “flow-through” income that otherwise would be taxed to the parents, likely at much higher rates. Also, if the new-for-2013 Medicare surtax applies to the parent’s flow-through income, that, too, may be reduced by wages paid to children.

If you would like to discuss further, please call your BNN advisor at 1.800.244.7444.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.