February 2012 - What Is the Kiddie Tax?

We all know that everyone has to file a tax return and pay their taxes, but does that apply to children, too? Many people may have heard of what is often referred to as the kiddie tax. The New Jersey Society of CPAs (NJSCPA) explains who is subject to it and what it may mean for your family’s tax planning:

Tax Rules for Dependents’ Income
The Internal Revenue Service (IRS) has special rules for children and any other dependents claimed on another taxpayer’s tax return. (In addition to children, the definition of dependents might also include older relatives who are younger or older than age 65.) Some of those rules apply to earned income, which is money a child might make at a summer or afterschool job. If your child earned $5,800 or less in 2011 and is claimed as a dependent on your return, then he or she does not have to pay tax on that income. If he or she earned more than $5,800 last year, then he or she will have to file a return and potentially pay income tax. (Your child is eligible to take business or charitable deductions that may lower taxable income.) There are also special rules for dependents who are married, older than age 65 or blind, so talk to your CPA if your dependents fall into any of these categories.

Defining Unearned Income
Dependents may also have to pay tax on unearned income, which includes dividends, interest and capital gains. This tax was introduced to prevent parents from shifting some of their investment income to their children in order to avoid paying tax. If your child had no more than $950 in investment income in 2011, then he or she does not have to file a return or pay tax on that income. Again, there are also special rules for dependents who are married, older than age 65 or blind.

Taxing Unearned Income
The rules become a little more complicated, however, if your child had unearned income greater than $950. While the first $950 is tax free, the second $950 of income is taxed at the child’s presumably low income tax rate. Any income greater than $1,900 is taxed at the parents’ marginal tax rate. That remains the case until the child becomes age 19, at which point he or she is no longer subject to the parents’ high tax rates. However, the child may be subject to the kiddie tax until age 23 if he or she is a full-time student. It may be possible to avoid filing a separate return for the child if the parents decide to include the child’s unearned income on their return and that income totals less than $9,500. Before taking this step, check to see if adding their income to your return will push you into a higher tax bracket. What happens if a child has both earned and unearned income? Then, it may be necessary to file a return and pay taxes depending on the separate and total income levels involved. Consult IRS Publication 929 for more details, or contact your local CPA with questions.

College Planning and the Kiddie Tax
Many people consider creating a college savings account in their child’s name. The kiddie tax is one reason why it’s a better idea for the parents to open a tax-advantaged option – such as a 529 savings plan or Coverdell plan. The money you earn on deposits in these accounts is tax free as long as the account proceeds are used for qualified education expenses. That means you don’t have to worry about related taxes – kiddie or otherwise.

Your Local CPA Can Help
As you get ready to file this year’s tax return, turn to your local CPA with all of your tax-related questions. He or she has the expertise needed to understand and resolve all of your financial concerns.

If you don’t have a CPA, you can easily locate one online using the NJSCPA’s free, online Find-A-CPA service. Just go to findacpa.org, and in a few clicks you can locate a highly qualified professional who can assist you.

To find more information on various personal financial matters, visit the NJSCPA’s public service website at MoneyMattersNJ.com. While visiting, you can subscribe to Your Money Matters, the NJSCPA's free, monthly email newsletter to receive valuable personal financial planning advice throughout the year.