Thinking of trying to save on your tax bill by putting some of your money into your child's bank accounts? Think again. The kiddie tax may stand in your way and cause your plans to backfire.
Kiddie Tax Basics
The kiddie tax is designed to stop parents, especially upper-income parents, from shifting unearned or investment income out of their high tax brackets and into their children's lower brackets. It works by taxing a child's investment income at the parents' marginal tax rate.That's the additional tax you'd pay if you earned one more dollar.
For kiddie tax purposes, unearned income is income other than the child's wages, salaries and other amounts paid for working. It applies mainly to investment income, like bank account interest, dividends, capital gains and other things.
Changes to the kiddie tax laws make it harder to save on taxes by shifting income to your children. At one time, parents could transfer investments to their children after they reached age 14 to avoid the kiddie tax. Now, however,the sale of an investment owned by a child before he turns 24 can trigger the kiddie tax.
The tax kicks in when a child's net unearned income is over $1,900.The first $950 isn't taxed at all. The second $950 is taxed at the child's tax rate. For 2010, that may be 5 or 10 percent, depending on the amount.
Anything over $1950 is taxed at the parents' tax rates, which could be 10, 15, 28, 33 or 35 percent, depending on the parents' income.
Who It Applies To
The kiddie tax applies to children who are:
- Under 18 years old and unmarried
- Under 18 with earned income (the child has a job), and the income is at least equal to half of the child's support for the tax year
- Full-time students who are over 18 but not over 24 years old at the end of the tax year and whose earned income is at least equal to half of the child's support for the tax year
For example, college students with jobs who pay for more than half of their support aren't subject to the kiddie tax.
Avoid the Tax
The kiddie tax may not have a big impact on your long-term goals to help your child, such as helping a child years in the future to buy a first home. It will come into play if there's a more immediate need or goal, such as financing a child's college education.
You have some options to minimize or even eliminate the effects of the kiddie tax.
Section 529 Plans
Section 529 plans, also known as Qualified Tuition Programs (QTPs), are great for saving for your children's college education. These plans receive favorable tax treatment.
Contributions to Section 529 programs aren't tax deductible. Federal income tax on earnings in a plan is deferred until withdrawals are made. Also, the earnings don't count as taxable income if they're used for qualified higher education expenses. So there is no kiddie tax with Section 529 programs as long as withdrawals aren't used for noneducational purposes.
Coverdell Education Savings Accounts
Coverdell Education Savings Accounts (ESAs), formerly known as Education Individual Retirement Accounts, are trust or custodial accounts used only for a specific child's educational expenses. Unlike Section 529 programs, amounts can be withdrawn tax-free to pay for elementary and secondary school expenses.
Like Section 529 programs, contributions to ESAs aren't tax deductible, but earnings on the account are tax-free as long as withdrawals are used to pay qualified education expenses. Withdrawals don't trigger the kiddie tax unless they're more than your qualified education expenses.
Since the kiddie tax applies only to unearned income, owners of family businesses may want to consider hiring their children to work in the business and paying them regular wages. You avoid the kiddie tax and get business-related tax benefits, too.
If a child has earnings from a job, you and the child can make contributions to a Roth IRA. Distributions from a child's Roth IRA don't trigger the kiddie tax if used to make a qualified first-time home purchase, even if the child is still a student and under age 24.
Roth IRA distributions for college expenses aren't taxable unless they're more than all of the contributions added together. For example, if the IRA's earned interest is more than what you or child actually put into it, the kiddie tax is triggered on the amount withdrawn that exceeds the contributions.
However, IRA earnings can be paid out tax-free when the child buys his first home.
Questions for Your Attorney
- Does the kiddie tax apply to an 18-year-old who isn't claimed as a dependent by either parent?
- Are there limits on how much can be contributed to an ESA?
- Do divorced parents have different kiddie tax problems than married parents?