The Kiddie Tax: What It Is and How It Affects Your Family’s Finances

The Kiddie Tax is a federal tax rule that applies to the unearned income of children under specific circumstances, impacting families who save or invest on behalf of their kids. Originally introduced in 1986, the Kiddie Tax prevents families from shifting unearned income, like dividends and interest, to children who fall under lower tax brackets to reduce their overall tax burden. Knowing how this tax works—and how to plan around it—can save families from unexpected tax bills and optimize their financial planning.

What is the Kiddie Tax?

The Kiddie Tax applies to dependent children under the age of 19 (or under 24 if a full-time student) who have unearned income exceeding a certain threshold. “Unearned income” typically includes:

• Dividends
• Interest
• Capital gains
• Trust income
• Royalties

The first $1,250 of a child’s unearned income is tax-free, and the next $1,250 is taxed at the child’s tax rate. Any amount beyond that $2,500 threshold is subject to the parent’s marginal tax rate, which is usually much higher.

When Does the Kiddie Tax Apply?

The Kiddie Tax applies if:

1. The child is under 18, or 18 with earned income not exceeding half their support costs, or 19–23 if a full-time student.
2. The child has unearned income exceeding $2,500.
3. The child is claimed as a dependent on their parent’s tax return.

Calculating the Kiddie Tax

Here’s a quick breakdown of how the Kiddie Tax works:

1. $1,250 of unearned income is tax-free for the child.
2. The next $1,250 is taxed at the child’s rate, generally 10%.
3. Any unearned income above $2,500 is taxed at the parent’s rate, which can be as high as 37% for high-income families.

Kiddie Tax Examples

To understand the Kiddie Tax better, let’s look at a few examples.

Example 1: Basic Kiddie Tax Scenario

Scenario: Alex, a 16-year-old, has $3,500 in dividend income from stocks gifted by his grandparents.

• $1,250 tax-free: The first $1,250 of unearned income is not taxed.
• Next $1,250 taxed at child’s rate: The next $1,250 is taxed at 10% (assuming a 10% rate).
  • Tax: $125
• Remaining $1,000 taxed at parent’s rate: Since Alex’s income is above $2,500, the remaining $1,000 is taxed at his parents’ rate of 24%.
  • Tax: $240

Total Tax Owed by Alex: $125 + $240 = $365

Example 2: Higher Earned Income

Scenario: Emma, a 19-year-old full-time college student, earns $1,200 from her part-time job and $4,500 in interest from a family savings account.

Since Emma’s total unearned income is $4,500, the Kiddie Tax applies.

• $1,250 tax-free: The first $1,250 of interest is not taxed.
• Next $1,250 taxed at child’s rate: This amount is taxed at Emma’s tax rate of 10%.
  • Tax: $125
• Remaining $2,000 taxed at parent’s rate: The remaining income above $2,500 is taxed at her parents’ marginal rate, which is 32%.
  • Tax: $640

Total Tax Owed by Emma: $125 + $640 = $765

Example 3: Child with Unearned and Earned Income

Scenario: Ethan, age 18, has $1,200 from a summer job and $3,000 in capital gains from stock investments.

• Since Ethan’s earned income ($1,200) is less than half of his total support, he qualifies for the Kiddie Tax rules on unearned income.
• $1,250 tax-free: The first $1,250 of his capital gains is not taxed.
• Next $1,250 taxed at child’s rate: This amount is taxed at 10%.
  • Tax: $125
• Remaining $500 taxed at parent’s rate: Since Ethan’s parents are in the 24% tax bracket, this $500 is taxed at 24%.
  • Tax: $120

Total Tax Owed by Ethan: $125 + $120 = $245

Strategies to Minimize the Kiddie Tax

If you anticipate that your child will have significant unearned income, here are some strategies that can help minimize the Kiddie Tax burden:

1. Invest in Tax-Efficient Accounts: Place assets in tax-advantaged accounts, like 529 college savings plans or Coverdell ESAs, where investments can grow tax-free when used for qualified education expenses.
2. Select Growth-Oriented Investments: Consider holding assets that generate long-term capital gains (rather than interest and dividends) since they can be taxed at lower rates. Additionally, growth-focused stocks generally don’t distribute as much in dividends, reducing annual taxable unearned income.
3. Gift Appreciating Assets Later: Instead of transferring assets early, consider gifting assets when your child is older (24 or beyond) to avoid the Kiddie Tax altogether. After this age, their income is generally taxed at their tax rate rather than the parents’ higher rate.
4. Use Municipal Bonds: Income from municipal bonds is often exempt from federal income tax, so they are a tax-efficient option for minors.
5. Contribute to a Roth IRA: If your child has earned income, they can contribute to a Roth IRA up to their earned income amount (or the maximum annual limit, whichever is less). This allows tax-free growth and withdrawals for retirement, avoiding annual tax implications.

Final Thoughts

The Kiddie Tax can surprise families with an unexpected tax burden on a child’s unearned income, especially if they’ve made investments or savings that generate dividends, interest, or capital gains. Understanding how this tax works and employing strategies to minimize it can help optimize family financial plans. By using a Kiddie Tax calculator, consulting a tax advisor, and implementing tax-efficient investment strategies, you can reduce the tax impact and continue to support your child’s financial future.