In my last blog post, I discussed whether your dependent children needed to file a tax return. I warned that unearned investment income in your child’s name is potentially subject to “Kiddie Tax.”
Kiddie Tax is actually not a tax at all. Instead, it is a limitation the IRS has put into place allowing a child under age 18 and full-time students under age 23 to have unearned income, such as, interest, dividends and capital gains, taxed at the child’s lower tax rate. Basically, some parents found that they could sometimes lower their income tax liability by shifting investment income to their child, since the child’s marginal tax bracket was lower than theirs. The Congress closed this loophole by enacting certain rules known as the kiddie tax.
The kiddie tax rules apply to those under age 18; those age 18 whose earned income doesn’t exceed one-half of their support, and children ages 19 to 23 who are full-time students and whose earned income doesn’t exceed one-half of their support. For tax year 2012, the first $950 in unearned income a child receives is not subject to tax. Income of more than $950 and up to $1,900 is allowed to be taxed at the child’s tax rate—which is usually less than the parent’s income tax rate. When the child receives unearned income of more than $1,900, the amount over $1,900 must be taxed at the parent’s rate.
There are two ways to report this income. The first option is to prepare a return for your child. The Kiddie Tax would be computed using Form 8615. If this option is chosen, the child’s unearned income over $1,900 will be calculated at the parent’s tax rate. If the child’s parents file separately, the parent’s highest tax bracket will be used. The second option is for you to report your child’s income on your tax return using Form 8814. The first $1,900 is taxed at the child’s rate, but is not included in the parent’s taxable income. The amount over $1,900 is then taxed at the parent’s rate.
You should consider both possibilities to see the total tax effect for each, as well as consider the effect each situation would have on your tax breaks to maximize your tax credits and deductions.
If you report your child’s unearned income on your tax return, you will omit the hassle of filing a separate return for the child. However, the additional income reported on your return could accelerate the phase-out of itemized deductions because of Adjusted Gross Income (AGI), limitations. With AGI limitations, additional income could also phase out your ability to deduct your IRA contributions. Finally, this additional income could reduce the amount of credits available to you. The child’s income can be included on your tax return only if the child’s unearned income is in the form of interest or dividends. If your child has any capital gains or losses, the child would be required to file a separate tax return.
Reporting your child’s unearned income on his own tax return would not affect your AGI. Therefore, your child's unearned income would not affect your eligibility for certain credits and deductions.
William G. Lako, Jr., CFP®, is a principal at Henssler Financial, and a co-host on Atlanta's longest running, most respected financial talk radio show "Money Talks" airing Sundays at 10 a.m. on Talk 920 AM, WGKA.