In light of tax season officially ending today (April 18th), we wanted to help you get a head start for a successful tax year in 2023!
One of the tax strategies we see underutilized is around children and their earned and unearned income. We’re going to explore what the Kiddie Tax is and some useful strategies parents can implement to help reduce their tax burden.
Firstly, there are two types of income that are important when figuring out your unique tax situation: earned and unearned. Earned income comes from your child when they have a part-time job and perform some kind of labor.
For 2023, the standard deduction for a child is total earned income plus $400, up to a maximum of $13,850. This means that your child can make up to $13,850 in earned income without having to pay any taxes. However, things change if your child has unearned income. In that case, you can figure out your child’s taxable income using the following formula:
And this is where the Kiddie Tax comes in.
The Kiddie Tax is a special tax law describing how the IRS treats children’s unearned income. Prior to 1986, parents could give assets, such as stock, to their children, and any income derived from those investments would be taxed at the children’s (presumably) lower tax rate.
It limits how much parents can give before paying their own higher tax rates on the unearned income derived from the assets they gifted. Unearned income includes dividends, interest, capital gains, and other forms of compensation not classified as labor.
In 2023, the first $1,250 of your child’s unearned income will be tax-free. The next bracket is between $1,250 and $2,500. Those funds will be taxed at the child’s marginal tax rate. Anything over $2,500 is taxed at the parent’s marginal tax rate.
Let’s use an example. Jake is a 16-year-old high school student who has some investments in his name. In 2023, Jake receives $4,000 in unearned income from bonds he got when he was younger and dividends from stocks. His parents have a marginal tax rate of 32%.
Now, if Jake worked a side job, those numbers would change. In that case, it is advised you seek out the services of a tax professional as things get complicated.
The Kiddie Tax by itself doesn’t provide a huge benefit. Still, you can combine it with other tax-saving investments and strategies that together can significantly reduce your tax burden while providing a return on investment.
Funds put into a 529 plan may not be tax deductible, but any assets purchased in them grow tax-free, keeping your child’s unearned income to a minimum. And even though distributions may not be deductible, they may fit into a gift strategy as part of an overall tax reduction strategy.
Again, Roth distributions are post-tax, but all earnings are tax-free. Therefore, like a 529, they reduce your child’s taxable unearned income.
Municipal bonds are often tax-free, even at the state and municipal levels.
Jake’s parents, the Smiths, have $100,000 for investments, but they want to keep taxes to a minimum. Keeping the Kiddie Tax in mind and working with a financial advisor, they develop a comprehensive investment strategy to build their investments tax-efficiently while also setting their children up for financial success.
Firstly, they fund a 529 savings plan and begin funding it. Next, they open up Custodial Roth IRA accounts and Custodial Brokerage Accounts. The children can place their earned income into the Roth account and purchase dividend-bearing and growth assets. The capital gains won’t be included in the child’s taxable unearned income, which may be taxed at the parent’s rate.
Next, they purchase a series of municipal bonds that grow in value over time. They carefully select bonds that grow tax-free so there isn’t a chance that their unearned income can push them over the kiddie tax threshold.
A child has many opportunities to utilize tax-free income. Firstly, up to $13,850 of earned income is tax-free and the first $1,250 of unearned income is tax-free. Secondly, children get a tax break with the next $1,250 of unearned income they receive. Anything after that, however, is taxed at the parent’s marginal tax rate.
Although the Kiddie Tax limits how much your children can benefit from their lower tax rate, there are still opportunities to capitalize on their tax advantages. An optimized kiddie tax strategy combined with a 529 college savings plan, a Roth IRA, and municipal bonds are great ways to keep overall taxes low. But this is only a partial list of ways to reduce overall taxable income. For example, you can utilize trusts and family partnerships to reduce your tax burden further.
A financial advisor can combine your complicated financial puzzle for a seamless and optimized tax-optimization strategy. Just click the button below.