John M. Hoffman & Associates CPAs

Frequently Asked Questions

Kiddie Tax

The “Kiddie Tax” as it is known is the tax that applies to dependent children with unearned income. Unearned income is typically investment income – interest, dividends, and capital gains. If the dependent child has unearned income over the threshold ($1,700 for tax year 2007), that income is taxed at the parent’s marginal tax bracket.

For years this rule applied to dependent children under the age of 14. For tax year 2006 the age limit was raised to under age 18 and in 2007 effective for 2008 and forward the age has been increased to age 23.

The effect of the kiddie tax rules is to negate the tax benefit of shifting assets and their income to dependent children all the way through college years. There is still a tax benefit for the first $1,700 of income, but barely enough to make it worth the effort.

For example, lets assume that a five year old with very generous grandparents has accumulated $50,000 that is invested in a bank money market which earns $2,500 for tax year 2007. Even if the parent’s elect to report this $2,500 on their tax return (as belonging to their 5 year old dependent) the tax treatment will be the same. The first $850 is tax free (standard deduction for the child), the next $850 is taxed at the child’s tax bracket (10% in this case) or $85, and the remaining $800 is taxed at the parent’s tax bracket.

So if the parent’s taxable income is $90,000 and the tax on that is $19,539, the tax on the extra $800 is the amount of tax on $90,800, $19,763 less the tax on the original $90,000, equating to $224 of tax on the $800. This $224 is added to the $85 from above for a total tax of $309.

This gets more complicated when the child has earned income. It should be noted that in the event of divorced parent’s the kiddie tax is computed at the marginal tax bracket of the custodial parent. In the event of married parent’s filing separate tax returns, the kiddie tax is computed at the marginal bracket of the parent with the higher income.

These complications and tax implications point out advantages of using section 529 plans for college savings where the tax implication is generally no tax.