The Internal Revenue Service (IRS) passed legislation in 1986 called the Kiddie Tax Law to prevent parents with a high net worth from transferring the reporting of interest earned on investments to their children. Parents sometimes took this action to avoid or lower their taxes since children are in a lower tax bracket than high-earning adults. This law remained unchanged until 2017 when the IRS included it in the Tax Cuts and Jobs Act (TCJA) that went into effect in 2018. These changes will remain in effect until the tax year 2025.
The Kiddie Tax Prior to the TCJA
Before the changes from TCJA went into effect, the IRS taxed all unearned income from children over a set amount. The amount was $2,100 in 2017. The parents would add the child’s unearned income to their tax return to determine their effective tax rate. Once calculated, the parents would transfer this rate to their child’s return to determine the tax obligation. The law impacted all children under age 19 or under age 24 if a full-time college student.
Understanding Unearned Income
The IRS considers unearned income to be most sources of income received from non-work activities such as interest on investment accounts. Parents sometimes purchase these assets in their child’s name to help fund higher education in addition to lowering their tax burden.
Changes to the Kiddie Tax Law Under TCJA
Under the old system, parents had to choose the greater of two tax calculations to use as the kiddie tax. The first was the amount of tax charged on the child’s income if the kiddie tax law in place at that time didn’t exist. The second was the total tax on the unearned income of a child assessed at the marginal tax rate of the parents. It also included the tax computed by the IRS using the remaining portion of taxable income at child rates.
Taxpayers found the second type complicated, especially for children of divorced parents or those who choose to file their returns separately. The old tax law could also become complex when parents reported unearned income for multiple children. As of the tax year 2018, the IRS no longer requires parents to add their child’s unearned income to their tax return to determine their effective tax rate. They can now determine their own and their child’s tax rate using the same table applied to trust funds.
Not All Parents Will Benefit from Kiddie Tax Changes
Although the IRS passed the TCJA to benefit more taxpayers, parents whose children receive a high amount of unearned income could find themselves paying more in taxes. At Nolan Accounting, we understand that keeping track of these changes can be frustrating and complex. If you plan to invoke the kiddie tax when you file your 2019 tax return, we encourage you to schedule a consultation with one of our accountants to ensure you’re well-informed about your options.