Calculating The Kiddie Tax

Congress extends childhood when it comes to calculating the kiddie tax.


Congress has officially extended childhood to age 18 – at least for purposes of calculating tax on investment income.

The “kiddie tax” specifies the age at which children become a separate tax entity from their parents for purposes of calculating tax on investment income. From birth to age 14, children could earn investment income up to two times the standard dependent deduction and be taxed at their tax rate, typically 10 percent. Any investment income over that threshold was taxed at the parents’ presumably higher tax rate. After 14, all investment income was taxed at the child’s lower rate.

The Tax Increase Prevention and Reconciliation Act of 2005, passed by Congress and signed by President Bush in May 2006, upped the age to 18. A child is considered to be 18 for the entire tax year in which he or she turns 18. For 2006, the standard dependent reduction is $850, putting the threshold for investment income at $1,700. That amount is taxed at thechild’s rate. Anything in excess of that amount is taxed at the parents’ rate.

The kiddie tax applies only to investment income, not earned income, so teens with jobs pay income tax at their rate, not their parents’. Individuals who marry before age 18 presumably aren’t children anymore, and if filing jointly, file at their own rate.

The change puts the future of accounts established under Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) in question. Under these acts, individuals can place assets in accounts for the benefit of a child but retain control of the assets as the trustee until the child reached the age of majority, usually 18. The tax benefit of moving assets to a child’s name may now be reduced, as income invested in these accounts over $1,700 will be taxed at the parents’ rate anyway.

UGMA/UTMA assets can be transferred to a 529 College Savings Plan for the same child, however. 529 accounts can receive only cash, so assets in an UGMA/UTMA may have to be liquidated and any realized gain would be subject to capital gains tax. Because UGMA/UTMA assets belong specifically to the child and 529 funds can be transferred to other family members, the account must be segmented. UGMA/UTMA assets within a 529 plan are not considered the property of the child for financial aid calculation.

With a capital gains rate of just 5% for kids in the 10% or 15% tax bracket, parents in higher brackets may still want to consider transferring appreciating assets. But parents who thought they had the years between 14 and 18 to sell assets in their child’s portfolio and potentially pay no capital gains tax have lost that option. Still, college students most often fall in a lower tax bracket than their parents, so selling after the child turns 18 will most likely mean less capital gains than if the parents had sold those assets.