Hello and welcome to this month’s Ask the CFP® segment. This month’s question is, “What is the kiddie tax?”
The “kiddie tax” is officially known as the Tax on A Child’s Investment and Other Unearned Income, and traces its roots back to the Tax Reform Act of 1986. This rule is designed to prevent parents from exploiting a tax loophole if their children were given large gifts of stock or other assets. In this case, the child could realize any gains or income from the investments and could be taxed at a far lower rate compared to the parent’s rate.
The kiddie tax applies only to unearned income …meaning from sources like interest, dividends, capital gains, rent, and royalties.
Assuming no earned income and the child does not itemize deductions, tax is calculated if the child’s unearned income exceeds 1,250 dollars. The next 1,250 dollars of income is taxed at the child’s tax rate. The income above 2,500 dollars is taxed at the parents’ marginal rate.
For example, let’s say Johnny’s parents gifted him 10,000 dollars worth of stock that had a cost basis of 1,000 dollars. After selling, there is a 9,000 dollar gain. The first 1,250 dollars of gain is excluded as this is the standard deduction available to a dependent child. The next 1,250 dollars is taxed at the child’s marginal tax rate. The remaining 6,500 dollars in gain is taxed at the parents’ marginal rate. Please note that these 1,250 dollar amounts listed are for the 2023 tax year and may change in the coming years.
As I mentioned before, this tax was put into place to keep parents from shifting assets to their children to take advantage of the lower tax rate on gains.
Generational wealth transfer requires detailed planning and this is an area where your financial planner, along with your legal and tax professionals, can provide valuable advice and guidance.
If you have a question about this topic or have a question for a future video, please send it to tfreeman@monetagroup.com.
Thanks for watching; we’ll see you next month.
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