Reporting a Child's Income on Your Tax Return

A parent may elect to include a child's income in the parent's income if the following are true:

the child's income consists entirely of interest and dividends

the child's income was more than $1,000 but less than $10,000 for 2013 (and 2014)

no estimated tax payments have been made in the name of the child

the child is not subject to backup withholding

The election must be made by the due date (including extensions) of the regular tax return.

Tip

Beginning in 2013, a new 3.8 percent net investment income tax may be imposed on individuals whose modified adjusted gross income exceeds $250,000 for joint filers, $125,000 for married taxpayers filing separately, and $200,000 for others. Trusts and estates with income over a certain amount are also subject to the NII tax. Form 8960, Net Investment Income Tax Individuals, Estates, and Trusts is attached to the tax return. For 2013, the IRS has provided taxpayers the ability to rely on more than one set of net investment income tax rules. The best choice varies by taxpayers and depends on the taxpayer's unique situation. Consult your advisor to determine which approach would be best for you.

Electing parents are then taxed on their child's income in excess of $2,000 for the 2013 tax year. They must also report an additional tax liability of either $100 if the child's taxable income is more than $1,000 or 10 percent of the child's income if it is less than $1,000.

The "kiddie tax" rules do have some advantages, though. One situation in which the election might produce significant tax savings is where the parent is, for example, in a high tax bracket and cannot deduct investment interest because he or she does not have enough investment income. The election should enable the parent to treat the child's income as the parent's own investment income so that the parent would be able to make use of the interest deduction. Charitable contribution deductions also may be increased.

Another benefit would be relief from having to file the complicated "kiddie tax" form (Form 8615, Tax for Children Under Age 18 With Investment Income of More Than $1,900), especially where more than one child is involved. However, the election involves filing Form 8814, Parents' Election to Report Child's Interest and Dividends, with the parents' annual tax return.

On the negative side, including the child's income could result in a reduction in the parents' deduction for medical expenses, IRA contributions and casualty losses. Also, the income may increase family state income taxes that otherwise would not be payable absent the election.

Save Money

The "kiddie" tax rules can be an unexpected burden for many families saving for college. However, the following gift-giving strategies can help reduce or even eliminate the kiddie tax and cut the overall family tax bill:

Buy Series EE bonds for the child and have the child elect to defer tax on the interest as it accrues.
Invest the child's money in securities with low yields but strong appreciation potential. If the securities are retained until age 18 or later, appreciation during the child's younger years escapes the kiddie tax.
Invest in raw land with appreciation potential. From the tax viewpoint, the land should be held until the child reaches age 18 or later.
Buy cash-value life insurance. Inside build-up from the policy will accumulate tax-free.
If the child is a beneficiary of a trust, coordinate trust income with income from outside of the trust. Although this is a less attractive option, one can still accumulate trust income up to the amount taxed to the trust at the 15 percent rate ($2,450 for tax years beginning in 2013 ($2,500 for 2014)).
Place UGMA and Uniform Transfers to Minors Act (UTMA) funds in tax-exempt bonds until the child reaches age 18. Tax-exempt zero coupon bonds may be a particularly good way to avoid the kiddie tax and build a college fund. Another approach is to buy stripped municipal bonds.
Buy market discount bonds for the child, keeping the current yield below $2,000 in 2013 (and 2014) so that the kiddie tax will not apply. When the bond is redeemed (or sold) after the child reaches age 18, the built-in discount will be taxed at the child's rates.
Set up a gift-giving program that keeps the child's unearned income below the 2013 (and 2014) $2,000 threshold (indexed for inflation) until he or she reaches age 18. For example, a cash gift to a 10-year-old child of $9,000, earning interest at eight percent, could grow over $3,000 by the time the child reaches age 18, and each year's interest will not exceed $1,300. Thereafter, the parent can set aside larger amounts for the child and continue to achieve effective family income-splitting.
Employ the child in the family business or in the performance of chores supporting the payment of earned income. The income can be sheltered by the standard deduction. Even a young child can perform compensable services.