As a parent or grandparent, you may want to help your children or grandchildren save for their future and build wealth by investing money in their name. However, it’s important to be aware of Kiddie Tax and how it may impact the parent’s tax liability.
What is Kiddie Tax?
Kiddie Tax is a tax law that applies to certain types of unearned income, such as interest, dividends, and capital gains, earned by children under the age of 19 (or under the age of 24 if a full-time student) from investments or other sources. The goal of this tax law is to prevent high-income families from avoiding taxes by transferring assets to their children in lower tax brackets.
How does Kiddie Tax work?
Under Kiddie Tax rules, a child’s unearned income above a certain amount is taxed at the same rate as the parent’s tax rate. The amount subject to Kiddie Tax is determined by the child’s age and the amount of their unearned income. For tax year 2022, the threshold for Kiddie Tax is $2,300 and for 2023 it is $2,500 of unearned income. If the child’s unearned income exceeds this threshold, the excess amount is taxed at the parent’s tax rate.
Earned vs. unearned income when it comes to Kiddie Tax
The difference between earned and unearned income is important when it comes to Kiddie Tax because Kiddie Tax only applies to unearned income. If a child earns income through work, such as from a part-time job, that income is not subject to Kiddie Tax. However, if the child receives unearned income, such as from interest or dividends from investments, capital gains from the sale of assets, and other passive income generated through investments or other sources, that income may be subject to Kiddie Tax if it exceeds the threshold amount for the tax year.
Kiddie Tax trap with an Inherited IRA
Once a child or grandchild inherits a traditional IRA, they become the beneficiary and must take required minimum distributions (RMDs) within 10 years. There are some eligible designated beneficiary exceptions based on the relationship between the beneficiary and the account owner that will allow the child to use stretch rules until age of majority. The RMDs are subject to income tax, and the child’s tax rate will depend on their individual tax situation. Under the Kiddie Tax rules, a child who inherits an IRA could also be subject to the same tax rates as their parents, depending on their age and the amount of their unearned income. This means that if the child’s unearned income, including RMDs from the inherited IRA, exceeds the Kiddie Tax threshold, the excess amount could be taxed at their parent’s tax rate.
Why is Kiddie Tax important?
If you’re considering investing or leaving money in a child’s name, it’s important to be aware of Kiddie Tax and how it may impact the parent’s tax liability. By transferring assets to a child’s name, they may be subject to Kiddie Tax and a higher tax rate on any unearned income they receive. However, there are strategies you can use to minimize the impact of Kiddie Tax, such as investing in tax-advantaged accounts like 529 college savings plans or Roth IRAs. In addition, it’s important to keep accurate records of the child’s income and file any required tax returns on time to avoid penalties or other consequences.
In conclusion, understanding Kiddie Tax and how it may impact your family’s tax liability is important if you’re considering investing money in a child’s name. By being aware of the rules and requirements, you can make informed decisions about how to save for your child’s future while minimizing the tax liability. If you have any questions about this or any other topic, our financial advisors in Austin would be happy to discuss further.
