We have a client couple who are great savers. Not only do they save more than 15 percent of their income for future goals, they save money for their children.
In addition to all of their other retirement goals, they wanted to save money for their children so that when they graduate from college, the kids will have a nest egg to help them launch. That starting point might be establishing a business, travel, or even using that money as a foundation for their own futures as great savers.
So, we determined approximately how much they needed to save to make that a reality and they were on their way. But about six years into this savings strategy, the savings (which were invested) started generating enough investment income that the children were subject to the kiddie tax. (Investment income = dividends, interest, and capital gains)
What is Kiddie Tax?
Simply put, the Kiddie Tax is a tax levied against your child’s investment income, but instead of them paying at their ultra-low, lack of a job marginal tax rate (read: zero), they pay at yours.
In effect, when it comes to investment income above a certain threshold, the IRS doesn’t distinguish between you and your dependent child, Suzy, even if she is only 10 years old and still lives under your roof. At some point, if your investments are successful...and we hope they are….her investment income will be subject to the same tax rate you pay on your investment income.
So, if you are like most people and your annual taxable income is between $75,000 and $470,000, you pay 15 percent on your long term capital gains. Not a huge deal, but there are a few other ways the IRS gets ya…
- If you make more than $470,000, your long term capital gains rate goes up to 20 percent...and so does Suzy’s.
- If the child’s investment income is non qualified dividends or short term capital gains, then the tax on that income will be at your marginal tax rate. So, if you are in the 33 percent tax bracket and you just took a $3,000 short term capital gain on your very shrewd investment -- well, plan to give the IRS about a third of that in taxes. If you do have non-qualified dividends or short term capital gains, you may have questions about how exactly this income impacts your marginal rate. That’s a great reason to reach out to your financial life guide and ask for help.
- The 3.8 percent Net Investment Income Tax: If you are subject to this tax (as is any family with total household income over $250,000), so are the kids! Add an additional 3.8 percent tax!
Here’s a breakdown of the levels of income that trigger the Kiddie Tax:
$ 0 to $ 1,050..................... not taxed
$ 1,051 to $ 2,100............... taxed at child’s rate
Over $2,100 ..................... taxed at parent’s rate
Earned income ................ taxed at child’s rate [link to blog on dependent taxes]
Beth is 17, earned $4,000 wages and $3,000 in interest for a total annual income of $7,000. Beth claims a standard deduction of $4,350, (Yes, there is a formula for figuring this out, too.) leaving $2,650 of taxable income. Beth pays tax at her parents’ rate on $900 ($3,000 interest minus $2,100). The remaining $1,750 is taxed at Beth’s rate.
Hard to keep track of right? And you probably haven’t even gotten down to reading the footnotes!
This infographic should help make it clearer:
If you have questions on dependent taxes it’s helpful to have an accountant and financial life guide look at the holistic picture of your family’s income.
Did you handle special tax and income circumstances to your best advantage last year?
Find out with a free review of your last return.