Don’t kid around with the kiddie tax

It’s never too early to begin talking to your children about financial planning and the basics of investing. After all, the sooner they understand, the savvier they’ll be about money later in life.

Of course, when it comes to children and investing there are some important issues that you as a parent should also consider to better guide your kids and serve your own financial responsibilities.

Children who earn income from capital gains, dividends, interest or real estate (which is officially called unearned income to distinguish from wages from a job, for example) can actually have a portion of those earnings taxed—and not at the low children’s rate, but at your much higher marginal tax rate.

That’s because of the kiddie tax. This tax is important for everyone to understand as it relates to larger responsibilities and decisions related to your family’s financial planning. That means you have to think carefully about which investments you put in your children’s names and which ones you don’t.

What is the kiddie tax?

The kiddie tax initially applied to the unearned income of children 14 and younger. Thanks to IRS rule changes, the tax now extends to children as old as 19 as long as they’re dependents (and up to 24 years old for fulltime students).

For 2016, the first $1,050 of a child’s investment earnings is untaxed. The following $1,050 of unearned income is subject to the children’s tax rate. Any amount above $2,100 is taxed at the parents’ marginal rate, which can be as high as 39.6 percent. The rule only applies to unearned income. Any income your child earns through a job is taxed at his or her rate.

Should your child file a tax return?

You might be tempted to include your child’s unearned income on your own tax return to keep things simple. But depending on your tax status, it could push you into a higher bracket. As a result, you might wind up paying more than if you kept your taxes separate.

Children must file a tax return if their unearned income exceeds $1,050. They must also file if their earned income is higher than the standard deduction ($6,300 for 2016). Even if your son or daughter earned less than $6,300, it might be worth filing a return to claim a refund for any taxes that were withheld.

The rules are different when children have both earned and unearned income. In that case, they must use an intricate set of calculations and comparisons to determine if a child must file a return:

1. First, the IRS asks you to add $350 to your dependent's earned income.

2. Compare the sum from step 1 to $1,050.

3. Now take the larger of the two numbers from step 2, and compare to $6,300.

4. Then take the smaller of the two numbers from step 3.

5. Now determine the dependent's gross income (the sum of earned plus unearned).

6. If the dependent's gross income is more than the number from 4, the child must file.

Illustrating this through an example: Let’s say your 16-year-old has $5,000 in wages and investment income of $300.

1. Add $350 to earned income: $350 + $5,000 = $5,350

2. Compare the sum from step 1 to $1,050: $5350 > $1,050

3. Take the larger of the numbers from step 2, and compare to $6,300: $5,350 < $6,300

4. Then take the smaller of the two numbers from step 3: $5,350

5. Now determine the dependent's gross income (the sum of earned plus unearned): $5000 + $300 = $5,300

6. If the dependent's gross income is more than the number from 4, the child must file:  $5,300 < $5,350

She won’t need to file because her gross income ($5,300) is less than the sum of her earned income plus $350 ($5,350).

On the other hand, if your teen has investment income of $700 and earnings of $500, she will be required to file because those sources of income together ($1200) amount to more than the $1,050 income threshold.

Suffice it to say, the kiddie tax can be complicated, but it has significant implications for both you and your child. A tax professional can help you figure out the right solution for your unique situation.

Plan with purpose

Think strategically about the types of investments you put in your children’s names. To minimize exposure to the kiddie tax, you may want to focus on investments that do not yield dividends and interest until children pass the kiddie tax window. Instead, consider investments whose value appreciates over time but don’t generate much or any tax until they’re sold. A financial advisor could help you understand what those investment types are, but some examples include:

  • Growth stocks or mutual funds: Growth companies typically reinvest profits in future growth instead of paying them out as dividends.
  • Municipal bonds: Interest from bonds issued by local and state governments is free from federal tax. If the bonds appreciate when they are sold, capital gains tax will be owed.
  • Tax-managed mutual funds: Portfolio managers run these funds with the intention of minimizing taxable income.

After all, at the heart of children’s tax considerations is the financial future of your family. With the right information and resources, you can help prepare your family for a more secure financial future.