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In 1986, the Internal Revenue Service (IRS) added the Kiddie Tax to its code to prevent wealthy parents from transferring some of their income to avoid paying taxes on it. Until last year, the IRS taxed all earned income from a child over $2,100 in a calendar year. The IRS defines a child as a dependent under age 19 or under age 24 if a full-time college student. The parents added the child’s unearned income to their own tax return to determine the applicable tax rate.

They would then use this tax rate on the child’s return to calculate the amount of tax owed. Unearned income includes anything not received from a job, such as stocks or dividends that parents took out in their child’s name.

Recent Changes to the Kiddie Tax

As of the 2018 tax filing year, the IRS no longer allows parents to add unearned income from a child to their own tax return when determining the payable rate. Instead, it determines the tax rate by using the same tax brackets applicable to a trust fund. Families will benefit most when multiple children have a modest amount of unearned income.

Prior to the change, the IRS added unearned income from all children and taxed each sibling the same regardless of their individual amount of unearned income. With the changes, each child will only pay the tax rate that matches his or her individual unearned income.

How Parents Can Make the Kiddie Tax Work Best for Their Family

Due to the recent changes, parents should manage the unearned income of their children more closely. This starts by performing a careful review of any assets titled to a child. It’s a good idea to check the allocation of each asset and determine whether it makes sense to invest in assets that pay capital gains and qualified dividends. That is because the IRS taxes these returns at a lower rate. Some good alternatives for purchasing financial assets in the name of a child include tax-exempt bonds, growth equity mutual funds, or value mutual funds.

Annually, parents should decide whether they can absorb losses for other investments to realize gains on different investments. Before doing so, parents should understand that losses from capital gains cannot dip below zero and that the IRS imposes a maximum of $1,500 to offset other types of ordinary income.

When it comes time to file taxes for 2019, parents can elect to report unearned income from their children directly on their own tax return. The income cannot come from any type of work and it must only represent dividend interest without any capital gains.

Schedule an Appointment with Capital Business Strategies to Learn More

Are you a parent looking to reduce your tax burden while also placing your children in the most advantageous financial position? We’re here to help. Please contact us today to request a consultation to learn more about the Kiddie Tax and other important tax strategies.