Before 1986, parents shifted investments to children so that interest and dividend income from the investments would be reported on the children’s returns. Often, children paid little or no tax because they sheltered the investment income with their standard deduction and exemption deduction and paid tax at their low tax rates.
In 1986, Congress attacked this tax strategy in three ways. First, only one exemption deduction per person is allowed. If you claim your child as a dependent on your return, your child loses his or her personal exemption deduction.
Second, if you claim your child as a dependent on your return, your child’s standard deduction decreases to the greater of $950 or the compensation income of the child plus $300. Thus, if your child’s compensation income is $400, your child’s standard deduction is $950. If your child’s compensation income is $1,800 then your child’s standard deduction is $2,100. This increased standard deduction is one advantage of hiring your children to work for you.
Third, if your child is subject to the kiddie tax, your child’s investment income over $1,900 may be taxed at your tax rate. Dependent children with investment income greater than $1,900 may be subject to the kiddie tax if they are under the age of 19 or are full-time students ages 19 to 23 who do not earn more than one-half of their own support. You can use the chart at the end of this article to help determine if your child is subject to the kiddie tax.
You file jointly with your spouse and report $120,000 of taxable income on your 2011 return. Your tax rate is 28%. Your 10-year old son receives $5,000 of interest income from certificates of deposit (CDs) given to him by your spouse. Your child’s tax computation is shown below.
Interest income $5,000
Standard deduction (950)
Exemption deduction (0)
---------
Taxable income $4,050
Taxed at your rate:
($5,000 - 1,900) $3,100
Tax rate and tax x 28%
---------
$868
Taxed at your child’s rate:
($4,050 - 3,100) $950
Tax from Table 96
---------
Child’s tax on $5,000 in interest income $964
Your child reports this tax on his or her own tax return. Your tax does
not change.
Including your child’s income on your return
If you have children subject to the kiddie tax who must pay tax, you can choose to include this income on your return by completing Form 8814. To do so, you must meet the following requirements:
- The income must be only from interest and dividends. None of the income can be from wages or capital gains other than mutual fund capital gain distributions,
- Your child’s interest and dividends must be more than $950 and less than $9,500, and
- Your child must not pay separate estimated tax payments.
Including your child’s income in your return on a Form 8814 may be a bad idea. By including your children’s income in your own return, you increase your adjusted gross income (AGI). As a result, your deductions could decrease. First, your deductions for medical expenses, casualty losses, and miscellaneous deductions are limited based on your AGI. To illustrate, your miscellaneous deductions are limited to amounts over 2% of your AGI. If you increase your AGI by including $5,000 of your child’s interest income in your income, you reduce your miscellaneous itemized deductions by $100 ($5,000 x 2%).
Second, if your employer’s retirement plan covers you, you must reduce the amount of the individual retirement account (IRA) contribution you can deduct if you are single and your AGI is over $56,000 or if you are married and your AGI is over $90,000 ($89,000 for 2010). If you include your child’s investment income in your return, you may decrease your IRA deduction.
Third, you are eligible to make a full Roth IRA contribution if your AGI is under $105,000, if you are single and under $167,000 ($166,000 for 2010), if you are married filing a joint return. Including your child’s investment income may cause you to exceed these amounts.
Many parents include their children’s income in their returns
to avoid the hassle or cost of filing Federal and state returns for their children. Although this reasoning is understandable, you may pay
more tax if you include your children’s income in your return.
Strategies to avoid the Kiddie Tax
You can use several strategies to avoid paying tax on your child’s investment income at your tax rates. First, you do not even need to file
a return for your child if your child’s income is under $950 unless he or she has net earnings from self-employment of $400 or more.
Second, your child who is potentially subject to the kiddie tax can receive $1,900 of investment income in addition to compensation income before paying tax at your rate. For 2011, your dependent child’s standard deduction is the greater of $950 or your child’s compensation income plus $300 up to $5,800.
If your child has $1,400 of investment income and no compensation income, then your child’s taxable income is $450 ($1,400 - 950). The income is taxed
at your child’s tax rate.
If your child has $2,000 of investment income and $6,000 of compensation income, then your child’s taxable income is $2,200 ($2,000 + 6,000 - 5,800).
Of the $2,200, $100 ($2,000 - 1,900) is taxed at your tax rate and $2,100
($2,200 - 100) is taxed at your child’s 10% tax rate.
In other words, compensation income can increase your child’s standard deduction and it does not change the amount of investment income your child can receive before your tax rate applies to his or her income.
Third, when your child’s investment income reaches $1,900,
consider investments that do not increase your child’s taxable income. Examples include:
Tax-exempt municipal bonds,
Growth stocks which pay no current dividends,
Real property which appreciates in value, and
Tax-deferred U.S. Savings bonds.
Fourth, split your child’s income with a trust. A trust is a separate
tax entity. Trusts pay tax on income that is kept in the trust and not paid
to your child. The first $2,300 of trust taxable income is taxed at a 15% tax rate. Thus, up to $4,200 ($2,300 in the trust and $1,900 distributed to your child) of income is taxed at a 10% or 15% tax rate. Although this strategy is worth considering, few parents use it because of the initial cost of setting up a trust and the annual cost of filing trust returns.
Many parents shift income to their children so they can save money
for the child’s college costs at a lower tax rate. However, until the child gets older, the child may pay tax at the parent’s tax rate. You can avoid this higher rate of tax by knowing how much income your child can receive before your tax rate applies and choosing investments that do not increase your child’s taxable income.
NOTE: If you are investing money in a child’s name to save money
for college, you should consider qualified tuition plans. They are generally better vehicles for such savings, particularly when the child is potentially subject to the kiddie tax.
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Julie Welch (Runtz), CPA, CFP, and Randy Gardner, LLM, CPA, CFP, are the authors of 101 Tax-Saving Ideas, 9th edition, published by Wealth Builders Press. To order ($27.95), call 816-561-1400, fax 816-561-6296 or email
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