Each year, I get a tax bill for our family dog. This county tax pays for animal control and shelter services. Our neighbors get a similar bill for their cats. But this kitty tax is entirely different from what’s known as the “kiddie tax”, which is the topic of this article… sorry if this is a disappointment for you cat lovers out there! The kiddie tax comes into play when someone is considering giving to a minor-age family member. Many of our clients are very generous to their loved ones, so we find ourselves discussing this sometimes-overlooked rule often.
When thinking about giving, we’re always looking for the most tax-efficient ways for our clients to make those gifts. Occasionally, a client asks about giving securities (stocks, bonds, etc.) to their minor-age child or, as grandparents, gifting shares to their minor-age grandchildren. As we talk with them about the idea, one thing we evaluate is whether the gift could trigger the kiddie tax. Considering options that avoid the kiddie tax can help to avoid unintended consequences when making gifts to young family members.
So, what is it? The kiddie tax is levied on unearned income (e.g., dividends & interest, capital gains, real estate) above a certain dollar amount received by a dependent child under age 18 (or full-time students at least age 19 and under 24). The rules subject a portion of the unearned income to the parents’ tax rate. Keep in mind, the kiddie tax does not apply to a child’s earned income from sources like part-time work.
Around 1986, the kiddie tax was created to dissuade parents from moving stocks, bonds and other income-producing assets to their minor/dependent children to avoid or minimize their own taxes. The rule applies regardless of who transfers the income-producing asset to the child—it could be a grandparent, aunt, uncle, etc.
It works by taxing unearned income above a certain threshold at the parent’s marginal federal income tax rate (10%, 12%, 22%, 24%, 32%, 35%, 37%), which presumably would be higher than the child’s marginal tax rate. For 2022, a child’s first $1,150 of net unearned income is offset by the child’s standard deduction. The next $1,150 in unearned income is taxed at the child’s tax rate. Any unearned income above $2,300 is taxed at the parents’ tax rate. If the parents’ tax rate is high, this can be a real surprise at tax time.
Here are a few common situations where it could be beneficial to ask your financial advisor or tax professional about potential kiddie tax implications:
- Giving securities to a minor child or grandchild.
- Gifting securities into and/or purchasing securities in a Uniform Gifts to Minor Act (UGMA) or Uniform Transfers to Minor Act (UTMA) titled to the minor child.
- Gifting/depositing cash into a UTMA/UGMA titled to the minor child and then purchasing securities with the cash.
- Naming a minor child as the beneficiary of retirement account if distributions will be needed from the inherited retirement account while the child is under age 18 (or under 24 if a full-time student).
Although the rules and calculations become a bit more complicated when the child has earned and unearned income, the take-home message is clear; the kiddie tax’s potential impacts need to be considered when designing a strategy to give income-producing or highly appreciated assets to minors.
Our advisor teams at Woodward Financial Advisors can help you navigate the kiddie tax and other rules around asset/income transfer so that you can give tax-efficiently while also minimizing potential unintended tax consequences.
Written by Austin Brown, CFP®
Article Graphic by Finn Brown