Understanding the Kiddie Tax

Do your children have income-generating assets in a custodial account? If so, be sure you understand the so-called kiddie tax.

This law was passed to discourage wealthier individuals from transferring assets to their children to take advantage of their lower tax rates. The kiddie tax has seen many iterations (see “Refund, anyone?” below), but current rules tax a minor child’s unearned income—including capital gains distributions, dividends, and interest income—at the parents’ tax rate if it exceeds the annual limit ($2,200 in 2021).

The tax applies to dependent children under the age of 18 at the end of the tax year (or full-time students younger than 24) and works like this:

• The first $1,100 of unearned income is covered by the kiddie tax’s standard deduction, so it isn’t taxed.
• The next $1,100 is taxed at the child’s marginal tax rate.
• Anything above $2,200 is taxed at the parents’ marginal tax rate.

If your child also has earned income, say from a summer job, the rules become more complicated. To learn more, see IRS Publication 929 or consult a tax advisor.