The Kiddie Tax

If you have no kids and don’t plan to, this may not be the riveting reading you expected today. Sorry. Today, we’re talking Kiddie Tax. I was this close (holding thumb and index finger very close) to titling today article “Hello Kiddie Tax” but readers advised than puns are the lowest form of humor and I aspire to a high level.

First, it stands to reason that few of our kids will be in a higher bracket than their parents. Exceptions, I know, but follow me. Long ago, parents took advantage of shifting wealth to their children and grandchildren. The fact is, you can gift anyone you like up to $13,000 this year and there are no tax consequences to doing so, in fact, there’s no form required at all. Since each parent can gift $13,000, that’s $26,000 a couple can pass to each of their children. As that pile of transferred wealth grows, it’s most likely to give off some income, whether it be interest, dividends, or capital gains within the account. The government wised up and implemented what is now fondly called the Kiddie Tax.

Simply put, the Kiddie Tax does not apply to earned income. For earned income, your child has her own standard deduction, and pays marginal rates starting at 10%, just as you or I would. The tax kicks in when it comes to unearned income. What we have in 2012 is the fact that children’s unearned income in excess of $1,900 will be taxed at the parents’ rate. To be specific, $950 isn’t taxed at all, and the next $950 is taxed at the child’s rate (presumably 10%), but after that, it’s the parents’ marginal rate for any money above the $1,900.

It may take a bit of planning, perhaps investing in non-dividend paying stocks, or shifting some of the funds into a Kiddie Roth, up to $5000 or the child’s earned income which ever is lower. Whether you are able to navigate around it or not, better to avoid the surprise this tax can spring on you.