Reporting a Child's Income on Child's Return

The unearned income (interest, dividends, investments, etc.) of a child under the age of 18 will be taxed at the parents' highest marginal tax rate, unless the parents make a special election to include the child's income on the parents' 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.

If the election isn't made, and the child files a separate return, no personal exemption is allowed if the child could have been claimed as a dependent on his or her parents' return.

Warning

This special rule (the "kiddie tax") applies to children under the age of 19 or under age 24 if the child is a full-time student whose earnings amount to less than one-half of his or her support.

However, the child can use up to $1,000 for 2013 (and 2014) of his or her standard deduction to offset unearned income. Thus, only unearned income in excess of $2,000 in 2013 (and 2014) is taxed at the parents' top marginal rate. These amounts are indexed annually for inflation.

In computing the parents' top marginal rate, all unearned income of children under age 18 in 2013 (and 2014) in excess of $2,000 is added to the parents' otherwise taxable income. The result is that, in some circumstances, the unearned income of a child under age 18 may be taxed at the 35 percent or 39.6 percent rate, while the parents' top rate would otherwise (based on their actual income) be lower.

Save Money

The main downside of the under 24 provision is that college age students can no longer sell off their appreciated investment accounts set up by the parents to cover current tuition. At a minimum, taking out student loans with interest until the year the student turns 24 will be necessary now to carry forward such a plan. Although these tax rules can be an unexpected burden for many families saving for college, 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) (indexed for inflation) 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 $2,000 threshold for 2013 (and 2014) (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.