The kiddie tax rules apply to those younger than age 18, those age 18 whose earned income doesn’t exceed one-half of their support, and children who are full-time students under the age of 24 and whose earned income doesn’t exceed one-half of their support. For the 2013 tax year, the first $1,000 in unearned income a child receives is not subject to tax. Income of more than $1,000 up to $2,000 is allowed to be taxed at the child’s tax rate — often 10 percent compared to the parents’ rate, which could be as high as 39.6 percent. A child’s unearned income in excess of $2,000, must be taxed at the parent’s rate.
Depending on your child’s investments, the kiddie tax threshold could be fairly easy or hard to reach. For example, if your daughter is gifted stocks with a low cost basis from her grandmother and you sell the stocks for a gain, $2,000 in investment income could be reached quickly. Alternatively, your child would need to hold roughly $90,000 of Home Depot stock to generate enough dividend income to reach the kiddie tax threshold. You may consider investing your child’s assets in companies that reinvest their profits rather than pay dividends or tax-managed mutual funds that are designed to generate little taxable income.
If your child has taxable unearned income, you have two ways to report it. You can prepare a return for your child, computing the kiddie tax using Form 8615. Beginning January 1, 2013, a child whose tax is figured on Form 8615 may be subject to the Net Investment Income Tax — a 3.8 percent tax on the lesser of net investment income or the excess of the child’s modified adjusted gross income over a threshold amount.
The second option is for you to report your child’s income on your tax return using Form 8814. The first $2,000 is taxed at the child’s rate and is not included in the parent’s taxable income. The amount over $2,000 is then taxed at the parent’s rate. The child’s income can be included on your tax return only if the child’s unearned income is in the form of interest, dividends, or capital gain distributions reported on Form 1099-DIV.
If you report your child’s unearned income on your tax return, you will eliminate the hassle of filing a separate return for the child. The additional income reported on your return could subject you to the Net Investment Income Tax and accelerate the phase-out of itemized deductions because of adjusted gross income limitations. Additional income could also restrict your ability to deduct your IRA contributions.
You should consider both filing options to see the total tax effect for each, as well as consider the effect each situation would have on your tax breaks to maximize your tax credits and deductions.