John M. Hoffman
The ďKiddie TaxĒ as it is known is the tax that
applies to dependent children with unearned income. Unearned income is typically
investment income Ė interest, dividends, and capital gains. If the dependent
child has unearned income over the threshold ($2,100 for tax year 2015 and 2016), that
income is taxed at the parentís marginal tax bracket.
This rule applies to dependent children
under the age of 23.
The effect of the kiddie tax rules is to negate
the tax benefit of shifting assets and their income to dependent children all
the way through college years. There is still a tax benefit for the first $2,100
of income, but barely enough to make it worth the effort.
For example, lets assume that a five year old
with very generous grandparents has accumulated $50,000 that is invested in a
(old fashioned) bank money market which earns $2,500 for tax year 2015. Even if the parentís
elect to report this $2,500 on their tax return (as belonging to their 5 year
old dependent) the tax treatment will be the same. The first $1,050 is tax free
(standard deduction for the child), the next $1,050 is taxed at the childís tax
bracket (10% in this case) or $105, and the remaining $400 is taxed at the
parentís tax bracket.
So if the parentís taxable income is $90,000 and
the tax on that is $19,539, the tax on the extra $800 is the amount of tax on
$90,800, $19,763 less the tax on the original $90,000, equating to $224 of tax
on the $800. This $224 is added to the $85 from above for a total tax of $309.
This gets more complicated when the child has
earned income. It should be noted that in the event of divorced parentís the
kiddie tax is computed at the marginal tax bracket of the custodial parent. In
the event of married parentís filing separate tax returns, the kiddie tax is
computed at the marginal bracket of the parent with the higher income.
These complications and tax implications point
out advantages of using section 529 plans for college savings where the tax
implication is generally no tax.