The purpose of the kiddie tax is to prevent the abuse of transferring income-generating assets to your children in order to benefit from lower tax rates. Per the Internal Revenue Service, the kiddie tax applies if:
- The child has unearned income, such as interest and dividends, above $2,200,
- Meets an age test,
- Does not file a return with married filing joint filing status,
- Has a filing requirement, and
- At least one parent is alive at the end of the tax year.
Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, for over 30 years a portion of the child’s unearned income was taxed at the parent’s marginal tax rate and The portion of tax that resulted from taxing unearned income at the parent’s marginal tax rate was allocated to all the siblings subject to the kiddie tax. Tax computation under these rules was often complex, especially for divorced parents or parents with a filing status of married filing separate.
The TCJA repealed this two-part calculation and directed and taxpayers to calculate kiddie tax on unearned income solely at the trust and estate tax rates starting tax year 2018. Generally, taxpayers saw their tax liability increase under these new rules since income intervals for trust and estate tax rates are much smaller compared to individuals.
Congress eventually acknowledged that the tax bill for certain individuals, such as first responders, emergency medical workers, and survivors military members, increased under these new rules. As a result, towards the end of 2019, the TCJA version of kiddie tax rules was repealed by the Further Consolidated Appropriation Act, 2020, and kiddie tax rules prior to TCJA where the child’s unearned income is partially taxed at the parent’s marginal tax rate and the child’s individual marginal tax became effective. This applies for tax year 2020 and beyond.
For tax years 2018 and 2019, the act gives taxpayers the option to elect either the TCJA version or pre-TCJA version of kiddie tax rules. Depending on the parent’s marginal tax rate and the amount of unearned income, it may be beneficial to amend 2018 and/or 2019 tax return(s) to take advantage of this option. For example, parents in a lower tax bracket who have children with a hefty amount of unearned income subject to kiddie tax may want to utilize their own marginal tax rate instead of the trust and estate tax brackets.
Due to the complexity of these rules, it is important to consult with your tax accountant to determine which rules will be more beneficial as each taxpayer’s situation is unique. It would also be worthwhile to discuss future tax planning strategies to mitigate the kiddie tax. For example, it may be effective to move investments to a 529 college savings plan if you are saving for your child’s education as the tax-free and distributions are also nontaxable if used for qualified education expenses.
If you need assistance with tax planning or have any additional questions, please contact your personal Sciarabba Walker contact or email email@example.com.
By Neha Saluja