Kiddie tax

From Wikicpa

Under the Kiddie Tax rules, a dependent child’s unearned income (usually from investments) will be taxed at the parent’s marginal federal income tax rate. This can be bad because the parent’s marginal rate could be as high as 35% in 2007, or 15% for long-term capital gains and qualified dividends (also 2007). If the Kiddie tax rules are ignored, the child’s single taxpayer rate could be as low as 10%, or 5% for long-term gains and dividends (or 0% for long term gains and dividends for 2008 through 2010).

Fortunately, the Kiddie Tax rules only apply to a dependent child’s unearned income in excess of the applicable annual threshold, which is $1,800 for 2008 ($1,700 for 2007). For post-2008 years, the threshold may be higher due to inflation adjustments. <See IRC Sec. 1(g)>.

Before 2006, the Kiddie Tax rules only applied to a dependent child who had not reached age 14 by year-end. In other words, it did not apply in the year the child turned 14 and for all future years. Unfortunately, the Tax Increase Prevention and Reconciliation Act of 2006 changed the magic age to 18, starting with 2006.

For example: Your dependent child owns investment assets held in a custodial account. In 2008 the investments will generate $5,000 of taxable income. Under the 2008 Kiddie tax rules, the first $900 of your child's income is sheltered by their $900 standard deduction. The next $900 will be taxed at only 10% (5% for long-term gains). The "Kiddie tax" now kicks in for all the remaining unearned income over $1,800. ($900 + $900). This income will be taxed at the parents' marginal federal rate.

The Kiddie Tax rules only apply if the child has at least one living parent and does not file a joint tax return.

2007 changes

The Small Business and Work Opportunity Tax Act of 2007 (signed 5/27/07 by President Bush and effective for taxable years beginning after that date) expands the kiddie tax to apply to children age 18 at the end of a taxable year and children over age 18 but under age 24 who are full-time students, if their earned income doesn't exceed 1/2 of their support.

Note that the applicability of the kiddie tax rules does not depend on a parent claiming the child as a dependent. Conceivably, a full-time student could have sufficient unearned income to provide more than half of his own support, but not enough earned income to escape the imposition of the kiddie tax.