It’s great to see college students, teenagers, and even younger children learn how to invest their money. Acquiring that knowledge at a young age lays the foundation for a lifetime of financial security.
But whenever money comes in, Uncle Sam wants his cut, too. So, while it’s important for young people to know how to grow their money, it’s equally important to understand how their investment earnings are going to be taxed.
Which brings us to the “kiddie tax.”
If a child with unearned income has to file a tax return, this quirk in the tax law can have a significant impact on his or her overall tax liability. How? By increasing the child’s tax rate on unearned income over a certain amount.
So, for all the young investors out there, here’s a rundown of the kiddie tax rules. We’ll explain what the kiddie tax is, who has to pay it, and how much it will cost you. There’s also an alternative option for parents who want to report their child’s income on their own tax return. Read on as we shine a light on the kiddie tax and a few related tax law provisions for a new generation of investors.
Related: Best Investment Apps for Beginners
What Is the Kiddie Tax?
The kiddie tax is a special rule that requires a child’s net unearned income above a certain amount to be taxed at the parent’s federal income tax rate. For the 2023 tax year, the kiddie tax kicks in if a child’s unearned income exceeds $2,500 (up from $2,300 for 2022).
As a result, if the kiddie tax applies for 2023, the child’s unearned income is taxed as follows:
- $0 through $1,250 of unearned income is tax-free
- $1,251 through $2,500 is taxed at the child’s rate
- Over $2,500 is taxed at the parents’ rate (kiddie tax)
The kiddie tax was added to the U.S. tax code by the Tax Reform Act of 1986 to close a loophole for wealthier parents. Before this special rule, parents were putting investments in their child’s name (e.g., in custodial accounts) and having all earnings from those investments taxed at the child’s income tax rate, which is typically lower than the parent’s federal income tax rate. The kiddie tax prevents parents from taking full advantage of this strategy by imposing the parent’s tax rate on a portion of the child’s unearned income.
Child’s Unearned Income Subject to the Kiddie Tax
The kiddie tax applies only to unearned income, which generally includes all of a child’s income other than salaries, wages, and other amounts received as pay for work actually performed (i.e., earned income). The unearned income must also be included in the child’s gross income.
Thus, among other things, the kiddie tax applies to a child’s:
- Taxable interest
- Dividend income
- Capital gains (including capital gain distributions)
- Taxable scholarship and fellowship grants not reported on Form W-2
- Unemployment compensation
- Taxable Social Security benefits and pension payments
- Income (other than earned income) received as the beneficiary of a trust
Investment income stemming from assets obtained with earned income—such as interest on wages deposited into a savings account—is considered unearned income, too. A child’s unearned income also includes income generated from property given to the child as a gift (including gifts made under the Uniform Transfers to Minors Act).
Who Is Subject to the Kiddie Tax?
Not all children who have unearned income are subject to the kiddie tax. The special rule only applies if all the following are true:
- The child had unearned income exceeding the annual threshold amount ($2,500 for the 2023 tax year).
- The child is required to file a tax return.
- The child satisfies the kiddie tax age requirements (see below).
- At least one of the child’s parents was alive at the end of the tax year.
- The child doesn’t file a joint tax return.
The kiddie tax rules also apply to legally adopted children and stepchildren. They also apply whether or not the child is a dependent.
Kiddie Tax Age Requirements
As noted above, only children of a certain age are subject to the kiddie tax. For the kiddie tax rules to apply, the child must either be:
- 17 years old or younger at the end of the tax year
- 18 years old at the end of the tax year and didn’t have earned income that was more than half of his or her support
- A full-time student 19 to 23 years old at the end of the tax year and didn’t have earned income that was more than half of his or her support
There are also some special rules for children born on Jan. 1, as shown in the following table used for the 2023 tax year:
Child’s Birthday Kiddie Tax Age for 2023 Tax Returns
Jan. 1, 2006 18
Jan. 1, 2005 19
Jan. 1, 2000 24
In addition, when calculating a child’s support, all amounts spent for food, lodging, clothing, education, medical and dental care, recreation, transportation, and similar necessities are included. If a child receives a scholarship, that money isn’t treated as support for full-time students.
Furthermore, a child is considered a full-time student if they’re enrolled for the number of hours or courses the school considers to be full-time attendance.
How to Calculate the Kiddie Tax
If a child’s unearned income qualifies for kiddie tax treatment, use Form 8615 to determine the tax due on the child’s taxable income, which includes both earned and unearned income. As you work through the form, the child’s unearned income is separated from earned income and taxed in three different ways.
- For the 2023 tax year, the first $1,250 of unearned income is tax-free ($1,150 for 2022). That’s because it’s subject to the maximum standard deduction for dependent children with no earned income, which is $1,250 for 2023. (A child’s standard deduction can be higher if he or she has earned income—up to the child’s earned income for the year plus $400, but not more than the regular standard deduction amount for his or filing status.)
- The next $1,250 of unearned income in 2023 ($1,150 for 2022) is taxed at the child’s own marginal tax rate. This represents the amount of unearned income below the $2,500 threshold that isn’t tax free.
- The remaining 2023 unearned income (i.e., above the $2,500 threshold in 2023) is taxed at the parents’ marginal tax rate.
Make sure Form 8615 is attached to the child’s return (it doesn’t need to be sent with the parents’ return).
Sloan, who is 16 years old and claimed as dependent on her parents’ joint tax return, has the following income in 2023:
- $100 of taxable interest from a savings account
- $5,400 of dividend income from an investment account set up by her parents
- $2,500 of capital gain distributions from an investment account set up by her grandparents
- $7,000 in wages from an after-school job and a summer job
Once all her unearned income ($8,000) and earned income ($7,000) is combined, and her standard deduction ($7,400) is subtracted, Sloan reports $7,600 of taxable income on her own tax return. Her parents report $200,000 of taxable income on their joint return.
The first $1,250 of her unearned income is tax-free ($0 tax), while the next $1,250 is taxed at the 10% rate ($125 tax), which is the rate applicable to a single filer with taxable income of $11,000 or less. The remaining $5,500 of unearned income is taxed at the parents’ tax rate of 24% ($1,320 tax). That’s a total of $1,445 of tax on Sloan’s unearned income ($125 + $1,320 = $1,445).
If all of Sloan’s $8,000 of unearned income had been taxed at her 10% rate, the total tax on that amount would only be $800. That’s $645 less than the tax owed under the kiddie tax rules.
Which Parent’s Tax Return to Use
If the child’s parents are married and file a joint tax return, simply pull the parents’ information from the joint return when working through the kiddie tax calculations on Form 8615. However, special rules apply if the parents aren’t married or don’t file jointly.
Married parents filing separate tax returns
If the child’s parents are married to each other, but file separate returns, use the return of the parent with the greater taxable income. However, if the parents don’t live together, and the parent with whom the child lives (i.e., the custodial parent) is considered “unmarried” for purposes of claiming the head-of-household filing status, the custodial parent’s return should be used.
Divorced or separated parents
If the parents are divorced or legally separated, use the custodial parent’s return if that parent hasn’t remarried. If that parent has remarried, the stepparent is considered the child’s other parent for kiddie tax purposes. As a result, if the custodial parent and the stepparent file a joint return, use that return. If the custodial parent and the stepparent file separate returns, use the return of the one with the greater taxable income.
Parents were never married
If a child’s parents have never been married to each other, but lived together all year, use the return of the parent with the greater taxable income. If the parents didn’t live together all year, the rules for divorced parents apply.
Reporting a Child’s Unearned Income on a Parent’s Tax Return
If a dependent child only has unearned income from interest and/or dividends (including capital gain distributions and Alaska Permanent Fund dividends), that income can be reported on a parent’s tax return if certain other conditions are met. In that case, the kiddie tax rules don’t apply, and the child doesn’t have to complete Form 8615 or file his or her own tax return.
Parents electing this option must file Form 8814 with their federal return.
For more information on this option, see Does My Child Have to File a Tax Return?
Related: Do You Have to File Taxes This Year?
Net Investment Income Tax
In addition to paying the kiddie tax, a child with unearned income might also have to pay what’s called the net investment income tax. This 3.8% surtax is imposed on your “net investment income” if your modified adjusted gross income exceeds a certain amount.
Among other things, your net investment income generally includes interest, dividend income, capital gains, rental and royalty income, and non-qualified annuities. It doesn’t include wages, unemployment compensation, Social Security benefits, alimony, and most self-employment income.
The income thresholds, which are based on your filing status, are as follows.
Filing Status Modified AGI Threshold
Single; Head of Household $200,000
Married Filing Separately $125,000
Married Filing Jointly; Surviving Spouse $250,000
Use Form 8960 to calculate the 3.8% tax.
Avoid the Kiddie Tax Rule with Tax-Free Investments
You can set up a 529 account or IRA as a custodial account. However, unlike other custodial accounts, 529 plans and IRAs don’t trigger the kiddie tax. That’s because they don’t generate unearned income for the child as money in the account grows. Instead, funds grow tax-free in 529 plans and IRAs.
Plus, assuming all requirements are met, funds withdrawn from these accounts are also tax-free. That’s truly a win-win from a tax perspective.