This blog was prepared with the assistance of Peter Weitsen, CPA, partner at WithumSmith+Brown, PC.

Typically, tax rules are not logical. For instance, one of the simplest concepts should be how children are taxed, yet tax rules covering children are unwieldly, confusing and pretty much defy common sense. Here’s how to understand some of those tax rules…

Earned Income

  • A minor child—even a baby—with earned income is taxed as an adult is taxed, at the same rates, but the standard deduction is limited to the amount of earned income.
  • Any earned income of a minor child is subject to Social Security or self-employment tax.
  • There is an exception to paying Social Security tax if the child is employed by and performs services for a parent’s proprietorship, single member LLC or partnership where both parents are the only owners and the child is under age 18.
  • Examples of jobs for which a parent might pay a child: Modeling in an advertisement, performing office chores, doing research on the Internet or product testing.
  • Any net proceeds from earned income can be deposited to the extent permitted into a tax-deferred account such as a traditional or Roth IRA or a solo 401K or Roth 401k. If funds are put in a deductible account, taxable income in excess of the standard deduction will be reduced. Depositing the funds in such accounts allows the child’s funds to accumulate without the income being currently taxed. If there would be no current deduction, then a Roth account should be considered.

Unearned Income

  • Unearned income may be subject to the Kiddie Tax. The Kiddie tax applies to a child who is 18 or under on the last day of the year…or 23 or under and a full-time student with at least one living parent…and who does not file a joint return. However, if the child is age 18 or older, the tax does not apply unless the child’s earned income is less than half of that child’s support and the child has not attained age 19 by the end of the year.
  • Examples of unearned income: Interest, nonqualified dividends, rents, short-term capital gains and required minimum distributions (RMDs) on inherited IRAs.
  • Unearned income up to $2,200 (2019 amount) will not be taxed.
  • Unearned income over $2,200 will be taxed at the estates and trusts tax rates.
  • For 2019, the estates and trusts top rate of 37% is reached when unearned income exceeds $12,750.
  • The net investment income (NII) tax of 3.8% applies on income above the estates and trusts top bracket amount of $12,750.
  • Long-term capital gains and dividends are taxed at preferential rates similar to the method used for taxing adults but applying brackets on the estates and trusts schedule. For example, the tax is zero for income up to the first bracket ceiling of $2,600. For income above $12,750, the top capital gains bracket is 20%, and in between the capital gains tax is 15%. The NII tax will apply for capital gains over $12,750.
  • Social Security benefits received by the child are taxed as unearned income. However, the taxable amount is subject to the same thresholds as a single taxpayer, eliminating many child recipients from having to pay tax on those benefits.
  • Because the top tax rate is attained at a pretty low amount, it is important to employ strategies for the child to have as little reportable income as possible. Ways to achieve this might include investing in US Savings Bonds with deferred interest…owning municipal bonds that pay federal tax-free interest… -choosing stocks that do not pay a dividend or that pay very low dividends…purchasing a fixed annuity with a maturity after the child exceeds the age limit…or purchasing a heavy cash-value life insurance policy. These are not recommendations—they are examples of ways to reduce the amount of taxable income that will be taxed at the top rates. Further, while we are covering tax minimization, the investment and risk aspects of the assets need to be considered. If you invest in mutual funds, be aware that many funds pay high capital gains dividends toward the end of the year.
  • Another strategy would be for parents or grandparents or others wanting to make gifts to the child to open a 529 college savings account instead of putting funds in the child’s name. The 529 account would accumulate income on either a tax-deferred or tax-free basis until it is either used for the intended purpose or withdrawn by the contributor. In either event, the child would not be taxed on the annual income earned in those accounts.
  • A child over the age of 18 can open a 529 account and name himself/herself as the beneficiary. This would remove the income from being taxed at the Kiddie Tax rates.
  • For children with unearned income below the maximum bracket, the Kiddie Tax might actually be lower now than it would have been before the 2017 federal tax law was enacted. Back then, the child’s income was taxed at the parent’s top marginal rate.
  • The Kiddie Tax is reported on IRS Form 8615 (Tax for Certain Children Who Have Unearned Income).

The above sets forth many of the typical tax rules. You might have a situation that falls outside of the typical range. Accordingly, it is suggested that you consult with a knowledgeable tax adviser before commencing any transactions that might affect how you are taxed.