How to use the Kiddie Tax to your favor

Ken Hargreaves, CFP®, AIF®, AWMA®, CRPC®
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:

Child’s Net Earned Income + Child’s Net Unearned Income – Child’s Standard Deduction = Child’s Taxable Income

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.

History of the Kiddie Tax

The Kiddie Tax came into effect as part of the Tax Reform Act of 1986, initially only applying to children 14 and under. This incentivized investors to shift more assets to older children. However, the age was raised to 19 in 2007. Significant changes to the Kiddie Tax didn’t occur again until 2017, when the TCJA modified the Kiddie Tax to align with higher Estate and Gift Tax rates. The Further Consolidated Appropriations Act of 2020 reversed and backdated those changes after the higher tax rates negatively impacted Gold Star families.

What are the limits?

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%.

To break it down:

$0 + $480 = $480 in taxes owed.

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.

Who qualifies for the Kiddie Tax?

Two types of people qualify for the kiddie tax.

The kiddie tax does not apply to:

How does the Kiddie Tax fit into my overall financial plan?

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.

Tax-Advantaged Accounts

Open A 529 College Savings Plan

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.

Open a Roth IRA

Again, Roth distributions are post-tax, but all earnings are tax-free. Therefore, like a 529, they reduce your child’s taxable unearned income.

Invest in tax-efficient assets

Municipal bonds are often tax-free, even at the state and municipal levels.

Putting it all together

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.

In Conclusion

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.
Disclosures

Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client’s portfolio. All investment strategies have the potential for profit or loss. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author/presenter as of the date of publication and are subject to change and do not constitute personalized investment advice.

A professional advisor should be consulted before implementing any investment strategy. WealthGen Advisors does not represent, warranty, or imply that the services or methods of analysis employed by the Firm can or will predict future results, successfully identify market tops or bottoms, or insulate clients from losses due to market corrections or declines. Investments are subject to market risks and potential loss of principal invested, and all investment strategies likewise have the potential for profit or loss. Past performance is no guarantee of future results.

Please note: While we strive to provide accurate and helpful information, we are not Certified Public Accountants (CPAs). The information in this article is intended for informational and educational purposes only and should not be interpreted as tax advice. It is crucial to consult with a CPA or tax professional to discuss you

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