In an attempt to accomplish the long-standing goal of saving money on their taxes, parents often try to transfer some of their income into their children’s names. This process is called “income shifting” as it attempts to shift income from the parent’s higher tax bracket into the child’s lower tax bracket. Unfortunately, the IRS is well aware of this strategy and uses the “kiddie tax” to prevent this from happening.
While some tax savings are available through this approach, the “kiddie tax” rules impose substantial limitations if:
- The child has not reached age 18 before the close of the tax year, or
- The child’s earned income is less than 50% of the child’s support and the child is age 18 or is a full-time student age 19 to 23.
For the kiddie tax to apply the child must satisfy the age requirements above and have more than $2,300 of unearned income for the 2022 tax year. Unearned income most commonly refers to investment income such as interest, dividends, and capital gains, which you receive on a Form 1099. If the child has less than $2,300 in unearned income, that income is simply taxed at the child’s tax rate and no kiddie tax applies. While it is possible to find some tax savings by shifting this income, the savings are not substantial.
If the kiddie tax rules apply to your children and they have over the prescribed amount of unearned income for the tax year (i.e., more than $2,300 for 2022), the child will be taxed on that excess amount at the parent’s income tax rate. This kiddie tax is calculated by computing the “allocable parental tax”. There are also special allocation rules if the parents have more than one child subject to the kiddie tax.
Note: Different rules applied for the 2018 and 2019 tax years when the kiddie tax was computed based on the estate and trusts’ tax rates, instead of the parent’s tax rates.
If you do elect to shift income to a child, the asset itself must be transferred to the child. It is not possible to shift only the income to the child as the income from an asset is attributable directly to its owner. Custodial accounts can be used to transfer an asset to a minor child. However, state laws can vary so be sure to check your state’s laws before transferring the assets.
Possible saving vehicles
The kiddie tax applies to the income from the assets shifted to a child, rather than the assets themselves. This means that the kiddie tax can be avoided by investing in assets that produce little or no taxable income. These include:
- Securities and mutual funds oriented toward capital growth;
- Vacant land expected to appreciate in value;
- Stock in a closely held family business, expected to become more valuable as the business expands, but pays little or no cash dividends;
- Tax-exempt municipal bonds and bond funds;
- U.S. Series EE bonds, for which recognition of income can be deferred until the bonds mature, the bonds are cashed in or an election to recognize income annually is made.
Investments that produce no taxable income — and which therefore aren’t subject to the kiddie tax — also include tax-advantaged savings vehicles such as:
- Traditional and Roth IRAs, which can be established or contributed to if the child has earned income;
- Qualified tuition programs (also known as “529 plans”); and
- Coverdell education savings accounts.
It is important to note that while the kiddie tax is focused on a child’s unearned income, their earned income (such as their W-2 wage) is still taxed at the child’s regular tax rates, regardless of the amount. Therefore, to save taxes within the family, consider employing the child at your own business and paying reasonable compensation.
Please contact your Wegner advisor if you have any questions on the kiddie tax and how to best take advantage of a child’s lower income tax rates.