TCP CPA Exam: How to Calculate the Tax on a Child’s Investment and Other Unearned Income

Introduction

What is Unearned Income?

In this article, we’ll cover how to calculate the tax on a child’s investment and other unearned income. Unearned income refers to any income that does not come from wages, salaries, or self-employment. For children, this typically includes income from investments or other financial assets such as interest from savings accounts, dividends from stocks, and capital gains from the sale of investments. Unlike earned income, which results from labor or services, unearned income is derived from passive sources, making it subject to different tax rules.

Some common types of unearned income for children include:

• Interest income: Earnings from savings accounts, bonds, or other interest-bearing investments.
• Dividends: Payments made to shareholders from a corporation’s profits.
• Capital gains: Profit from the sale of an asset such as stocks, bonds, or mutual funds.
• Other income sources: This could also include income from trust funds, rental properties, and certain custodial accounts like Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts.

Why Understanding Children’s Unearned Income Taxation is Important

Taxation of a child’s unearned income has specific rules under what is known as the “Kiddie Tax.” These rules were established to prevent families from shifting income to their children, who generally fall into lower tax brackets, to avoid paying higher taxes. Understanding how these rules work is essential for tax professionals, as it affects families with children who have investments or other forms of passive income.

Misapplying or overlooking the Kiddie Tax can lead to penalties, underpayment of taxes, or an overpayment that could have been avoided through proper tax planning. Therefore, knowing how to calculate taxes on a child’s unearned income is crucial for providing accurate tax advice.

Relevance to Tax Professionals

Tax professionals, particularly those focused on family tax planning or high-net-worth individuals, need to be well-versed in the Kiddie Tax rules. With increasing numbers of families engaging in financial planning that involves transferring assets to their children, professionals must ensure compliance with the tax laws governing unearned income.

For those studying for the TCP CPA exam, mastering the taxation of unearned income for minors is essential. Questions on the Kiddie Tax and unearned income calculations are frequent exam topics, making it an important area of knowledge for passing the exam and practicing tax advisory services effectively.

This topic is also relevant when advising on broader estate and gift tax strategies, as managing unearned income is a key component of wealth transfer planning.

What Constitutes a Child’s Unearned Income

Definition of Unearned Income for Tax Purposes

For tax purposes, unearned income refers to income that is not derived from active work, employment, or business activities. Instead, it comes from passive sources such as investments, savings, and other financial instruments. Unlike earned income, which is subject to payroll taxes and income tax brackets based on wages or self-employment, unearned income is taxed under specific rules, especially when it applies to children.

Some of the key types of unearned income include:

• Interest Income: Earnings from interest on savings accounts, certificates of deposit (CDs), bonds, and other interest-bearing investments.
• Dividends: Payments received by shareholders from a corporation’s profits, typically from owning stock in a company.
• Capital Gains: Profit made from the sale of an investment, such as stocks, bonds, mutual funds, or real estate. This can either be short-term or long-term, depending on how long the investment was held before the sale.
• Other Passive Income: This may also include rental income, income from trusts, or royalties.

Differentiating Earned vs. Unearned Income

Understanding the distinction between earned and unearned income is critical, especially when it comes to how they are taxed.

• Earned Income: This type of income is a result of personal effort and labor, such as wages, salaries, and tips. It is subject to regular income tax rates, FICA taxes (Social Security and Medicare), and potentially self-employment tax. Children can earn this type of income from part-time jobs, internships, or self-employment.
• Unearned Income: As mentioned, unearned income arises from investments and other passive sources. It is not subject to FICA taxes but is taxed differently, with specific rules for children’s unearned income under the Kiddie Tax. Importantly, the tax rate for a child’s unearned income may be higher, as income above a certain threshold can be taxed at the parents’ marginal tax rate.

Common Sources of Unearned Income for Children

Children can have several sources of unearned income, particularly from financial gifts or investments made by family members. These sources can include:

• Custodial Accounts (UGMA/UTMA): These accounts allow parents or guardians to hold and manage assets for a child until they reach the age of majority. The funds in these accounts often generate income in the form of interest, dividends, or capital gains, which are subject to the Kiddie Tax rules.
• Investment Portfolios: Children may receive investments such as stocks, bonds, or mutual funds through gifts or as part of an inheritance. Any income generated from these assets, such as dividends or the sale of investments (capital gains), counts as unearned income.
• Trust Funds: Income from trust funds is another source of unearned income for minors. Trusts can be set up to provide financial support to children, and the earnings from the trust’s investments can be subject to Kiddie Tax rules depending on the nature of the income.

By understanding these sources and the nature of unearned income, tax professionals can properly identify how these incomes are taxed and advise families accordingly. The treatment of a child’s unearned income under tax law has distinct rules and thresholds, making it a critical area of focus for those studying for the TCP CPA exam.

Tax Rules Applicable to a Child’s Unearned Income (The “Kiddie Tax”)

Explanation of the “Kiddie Tax” (Internal Revenue Code Section 1(g))

The Kiddie Tax, governed by Internal Revenue Code Section 1(g), was established to prevent families from shifting income to children to take advantage of their typically lower tax rates. Specifically, it applies to the unearned income of children under certain age thresholds, ensuring that income exceeding a specified amount is taxed at the parents’ higher tax rate rather than the child’s lower rate. The goal is to limit the tax benefits of transferring investment income to children in an attempt to minimize overall family tax liability.

Under the Kiddie Tax rules, a child’s unearned income above a certain threshold is taxed at the parent’s marginal tax rate, while the first portion of unearned income is taxed at the child’s own lower rate. This two-tiered taxation structure applies to children who meet certain age and filing status requirements, as detailed below.

Thresholds and Limits for Unearned Income Taxation

The taxation of a child’s unearned income is broken into two parts: income taxed at the child’s rate and income taxed at the parent’s rate. These thresholds are adjusted annually to account for inflation.

1. Income Subject to the Child’s Tax Rate

The first $1,250 of a child’s unearned income is generally exempt from taxation due to the standard deduction for dependents. The next $1,250 is taxed at the child’s tax rate, which is typically 10%, depending on the applicable tax bracket. This allows a modest amount of unearned income to be taxed at a relatively low rate.

2. Income Subject to the Parent’s Tax Rate

Any unearned income above $2,500 is taxed at the parent’s marginal tax rate, which could be significantly higher than the child’s rate. This means that if a child’s investment income exceeds the $2,500 threshold, the excess is taxed as though it were earned by the parent, effectively limiting the tax advantage of income-shifting strategies.

The Kiddie Tax thresholds are as follows:

• $0 to $1,250: No tax (standard deduction)
• $1,251 to $2,500: Taxed at the child’s tax rate
• Above $2,500: Taxed at the parent’s tax rate

This progression ensures that only modest amounts of unearned income benefit from the child’s lower tax bracket, with larger amounts being taxed at the parents’ higher rate.

Age and Filing Status Requirements for the Kiddie Tax

The Kiddie Tax rules apply to children who meet certain age and filing status criteria. Specifically, it applies to:

• Children under age 18: All unearned income over the threshold is subject to the Kiddie Tax.
• Children age 18: If the child’s earned income does not exceed half of their support, the Kiddie Tax applies.
• Full-time students aged 19–23: The Kiddie Tax also applies to students under the age of 24 if their earned income does not exceed half of their support and they are full-time students.

Additionally, the child must be required to file a tax return for the Kiddie Tax to apply. If the child’s total unearned income exceeds $1,250, they are required to file a tax return and potentially be subject to the Kiddie Tax. In some cases, parents can elect to include their child’s income on their tax return (via Form 8814), which simplifies filing but could lead to different tax outcomes.

Understanding these thresholds, tax rates, and age requirements is crucial for tax professionals advising families or preparing tax returns for children with investment income. It ensures that the correct tax treatment is applied, avoiding underreporting of income and ensuring compliance with the Kiddie Tax rules.

Step-by-Step Process to Calculate Tax on a Child’s Unearned Income

Step 1: Identifying Total Unearned Income

The first step in calculating the tax on a child’s unearned income is to identify all sources of unearned income for the tax year. Unearned income is typically passive income from financial investments or savings. Common sources include:

• Interest income from savings accounts, bonds, or certificates of deposit.
• Dividends from stocks, mutual funds, or exchange-traded funds (ETFs).
• Capital gains from the sale of investments, such as stocks, bonds, or mutual funds.
• Other sources such as income from trust funds, royalties, rental income, or custodial accounts (UGMA/UTMA).

Once all sources of unearned income are identified, calculate the total unearned income for the child. This will form the basis for determining whether the Kiddie Tax applies.

Step 2: Determining if the Kiddie Tax Applies

After identifying the total unearned income, the next step is to determine if the Kiddie Tax rules apply. The Kiddie Tax applies to children under certain age thresholds and filing statuses. Specifically, it applies to:

• Children under age 18 at the end of the tax year.
• Children aged 18, if their earned income does not exceed half of their own support.
• Full-time students aged 19–23, if their earned income does not exceed half of their own support and they are claimed as dependents on their parent’s tax return.

Additionally, the child’s total unearned income must exceed $2,500 for the Kiddie Tax to apply. If the child’s unearned income is less than this amount, only the child’s own tax rates apply. If unearned income exceeds this threshold, the portion above $2,500 may be subject to taxation at the parent’s tax rate.

Step 3: Calculating the Tax Based on Unearned Income

Once you’ve determined that the Kiddie Tax applies, the next step is to calculate the tax on the child’s unearned income. This calculation involves determining how much of the income is taxed at the child’s rate and how much is taxed at the parent’s rate.

1. Income Subject to the Child’s Tax Rate

The first $1,250 of unearned income is generally not taxable due to the child’s standard deduction for dependents. The next $1,250 is taxed at the child’s rate, typically 10%.

2. Income Subject to the Kiddie Tax (Taxed at the Parent’s Rate)

Any unearned income over $2,500 is subject to the Kiddie Tax and will be taxed at the parent’s marginal tax rate. This rule ensures that income above this threshold is taxed at the higher rate, preventing tax benefits from income-shifting.

Example 1: Child with Unearned Income of $1,800

• The first $1,250 of unearned income is covered by the standard deduction and is not taxable.
• The remaining $550 ($1,800 – $1,250) is taxed at the child’s rate of 10%.
• No Kiddie Tax applies, as the total unearned income does not exceed $2,500.

Example 2: Child with Unearned Income of $4,000

• The first $1,250 is exempt from taxation.
• The next $1,250 is taxed at the child’s rate (10%).
• The remaining $1,500 ($4,000 – $2,500) is taxed at the parent’s marginal tax rate, say 24%.

The calculation ensures that both the child’s and parent’s rates are applied correctly to different portions of the income.

Step 4: Reporting the Income on Tax Returns

Once the tax calculation is complete, it must be properly reported on the child’s tax return or the parent’s, depending on the situation.

• IRS Form 8615: Tax for Certain Children Who Have Unearned Income
  Children who have unearned income above $2,500 must file IRS Form 8615. This form helps calculate the Kiddie Tax, applying the appropriate rates to the child’s unearned income.
• Filing Requirements and Parental Reporting Options
  If the child’s unearned income is less than $11,000, parents may choose to report their child’s unearned income on their own return by filing IRS Form 8814. This can simplify filing for the family, although it may result in higher tax liability depending on the parents’ tax situation.

Understanding how to complete and file these forms ensures proper compliance with IRS rules and helps avoid penalties or underpayments.

Additional Considerations

Special Cases Where the Child Has Both Earned and Unearned Income

In cases where a child has both earned and unearned income, special tax rules apply. The child’s earned income, such as wages from a part-time job, is taxed at the standard tax rates applicable to the child. Unearned income, on the other hand, may be subject to the Kiddie Tax if it exceeds the $2,500 threshold.

However, it’s important to understand how the standard deduction works in these situations. A child’s standard deduction is calculated as the greater of $1,250 or their earned income plus $400, up to a maximum of $13,850 (for 2024). This allows earned income to offset the taxable amount of unearned income up to a point, reducing the overall tax liability.

For example, if a child has $5,000 of earned income and $2,000 of unearned income, their standard deduction would cover the unearned income entirely, eliminating the need for further tax on the unearned portion.

Capital Gains Tax on Investments Held by the Child

When a child holds investments that generate capital gains, these gains are considered unearned income and are subject to specific tax rules. The capital gains tax rate applied depends on whether the gains are short-term or long-term:

• Short-term capital gains (on assets held for less than one year) are taxed as ordinary income, subject to either the child’s tax rate or, if applicable, the Kiddie Tax.
• Long-term capital gains (on assets held for more than one year) are taxed at preferential rates, either 0%, 15%, or 20%, depending on income levels.

If the child’s total unearned income exceeds $2,500, the capital gains beyond this threshold could be taxed at the parent’s marginal tax rate under the Kiddie Tax rules. As a result, parents and tax professionals must plan the timing of investment sales to minimize the impact of higher taxation on the child’s gains.

Impact of Tax-Advantaged Accounts (e.g., 529 Plans, UGMA/UTMA Accounts)

Certain tax-advantaged accounts play a significant role in managing a child’s unearned income and reducing tax liability:

• 529 Plans: These are education savings accounts that allow investments to grow tax-free, provided the funds are used for qualified educational expenses. Withdrawals used for educational purposes are not taxed, and contributions may also be eligible for state tax deductions. Investments within a 529 plan are not considered unearned income, and they do not trigger the Kiddie Tax.
• UGMA/UTMA Accounts: These custodial accounts hold assets in a child’s name until they reach the age of majority. While these accounts offer flexibility for non-educational expenses, the income generated from the assets is considered unearned income and may be subject to Kiddie Tax. Income from interest, dividends, or capital gains realized in these accounts must be reported, and amounts exceeding $2,500 are taxed at the parent’s rate.

Using tax-advantaged accounts like 529 plans can help reduce the exposure of a child’s investment income to the Kiddie Tax, particularly if the funds are earmarked for educational purposes.

When Parents May Include a Child’s Income on Their Return (Form 8814)

Parents have the option to include a child’s unearned income on their own tax return using IRS Form 8814, provided certain conditions are met:

• The child is under 19 years old (or under 24 if a full-time student).
• The child’s only income is from interest, dividends, and capital gains.
• The child’s total unearned income is less than $11,000 for the tax year.

By including the child’s income on their own return, parents avoid the need to file a separate tax return for the child. However, this option comes with potential drawbacks. The child’s income will be taxed at the parents’ marginal tax rate, and the child loses access to the standard deduction that would have applied if they filed their own return.

This option is typically advantageous when the child’s income is low and the parents’ tax rate is not significantly higher than the child’s. Tax professionals should carefully evaluate both options to determine which approach results in the lowest overall tax liability for the family.

By considering these additional factors, tax professionals and families can ensure that a child’s unearned income is properly managed and reported, minimizing the potential tax burden and ensuring compliance with IRS regulations.

Strategies to Reduce the Kiddie Tax

Tax Planning Strategies for Parents and Children

Effective tax planning can help families minimize the Kiddie Tax’s impact on a child’s unearned income. Some of the most beneficial strategies involve using tax-advantaged accounts and structuring investments in ways that reduce taxable income.

• Use of Tax-Advantaged Accounts:
  One of the most effective ways to reduce or avoid the Kiddie Tax is through tax-advantaged accounts like 529 Plans and Roth IRAs. A 529 Plan allows investments to grow tax-free if the funds are used for qualified educational expenses, such as college tuition. Since the earnings within a 529 Plan are not considered unearned income, they are exempt from the Kiddie Tax rules.
  Another option is a Roth IRA, where a child with earned income can contribute. While the contributions are made with after-tax dollars, any investment earnings within the Roth IRA grow tax-free, and qualified withdrawals are also tax-free, shielding the child’s unearned income from the Kiddie Tax.
• UGMA/UTMA Accounts:
  While custodial accounts under the Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) are not tax-advantaged in the same way as 529 Plans, they allow parents to transfer assets to a child. Families should be cautious, however, because the income generated from these accounts is subject to the Kiddie Tax. Careful management of these accounts is key to reducing the tax burden, as discussed further below.

Timing of Investment Sales and Capital Gains Realization

The timing of investment sales plays a critical role in minimizing the tax impact of a child’s unearned income, especially when capital gains are involved.

• Delaying the Realization of Capital Gains:
  To avoid triggering the Kiddie Tax, parents and children can strategically time when capital gains are realized. If possible, delaying the sale of investments that generate capital gains until the child is no longer subject to the Kiddie Tax (i.e., after they turn 24 or when their earned income exceeds half of their support) can reduce or eliminate the Kiddie Tax entirely.
• Long-Term vs. Short-Term Capital Gains:
  Another approach is to focus on long-term capital gains, which are taxed at preferential rates (0%, 15%, or 20%) compared to short-term gains, which are taxed as ordinary income. Long-term capital gains on assets held for more than one year may result in lower taxation, even if some of the income is subject to the Kiddie Tax.

Avoiding Higher Taxation Through Gift Tax Strategies

Parents and grandparents can use gift tax strategies to shift wealth to children in a tax-efficient manner, avoiding higher taxation due to the Kiddie Tax or other income taxes.

• Annual Gift Exclusion:
  The annual gift tax exclusion allows individuals to give up to $17,000 (in 2024) per recipient, per year, without triggering gift taxes. By making strategic use of this exclusion, parents can transfer assets to their children over time, potentially reducing the amount of income-producing investments held in their own name. This can minimize their taxable income while transferring wealth to the next generation.
• Gifting Low-Yield Investments:
  To minimize the Kiddie Tax’s impact, parents can focus on transferring low-yield investments, such as bonds with low interest rates, rather than high-yield assets like stocks that generate significant dividends. By reducing the child’s unearned income from these transfers, the risk of triggering the Kiddie Tax is lowered.
• Gifting Appreciated Assets to Avoid Future Taxes:
  Gifting appreciated assets can be an effective way to lower the overall tax burden in the long run. Parents can gift stocks or other investments to their children, who will inherit the cost basis. While the child will pay capital gains tax when they eventually sell the asset, they may qualify for lower tax rates if they hold the investment long enough to benefit from long-term capital gains tax treatment.

By utilizing these strategies, families can lower the taxable income subject to the Kiddie Tax, manage capital gains more effectively, and maximize the use of tax-advantaged accounts. Tax professionals should consider these options when advising clients on reducing tax liability for children’s unearned income.

Common Mistakes and Pitfalls

Failing to Account for the Kiddie Tax

One of the most frequent mistakes made by parents and tax preparers is failing to account for the Kiddie Tax. This often happens when families underestimate the tax implications of a child’s unearned income, particularly when the child has multiple sources of passive income. If the unearned income exceeds the $2,500 threshold, the Kiddie Tax rules apply, and the income above this limit is taxed at the parents’ higher marginal tax rate.

Failing to account for the Kiddie Tax can result in underpayment of taxes and potential penalties. It is essential to carefully track all sources of a child’s unearned income and ensure that the correct tax treatment is applied once the income surpasses the threshold.

Incorrectly Applying the Tax Brackets

Another common pitfall is the incorrect application of tax brackets, especially when calculating the portion of unearned income that should be taxed at the child’s rate versus the portion taxed at the parent’s rate. Misunderstanding the structure of the Kiddie Tax can lead to errors in calculating the child’s tax liability.

To avoid this, it’s important to follow the Kiddie Tax progression:

• The first $1,250 of unearned income is covered by the child’s standard deduction.
• The next $1,250 is taxed at the child’s tax rate.
• Any unearned income over $2,500 is taxed at the parent’s marginal tax rate.

Correctly applying these tax brackets ensures that the appropriate amount of tax is paid and that there are no errors on the child’s or the parents’ tax returns.

Overlooking Investment Income Thresholds for Children

Another frequent oversight is failing to recognize when a child’s unearned income exceeds the threshold for triggering the Kiddie Tax. Parents may be unaware of the $2,500 limit, particularly if their child has income from multiple sources such as interest, dividends, and capital gains.

Additionally, investment income that accumulates over time, such as reinvested dividends, may go unnoticed until tax filing time, leading to missed reporting of taxable income. It’s crucial to monitor the total unearned income throughout the year to avoid underreporting and the potential for penalties.

Parents and tax professionals should ensure that all income sources are properly tracked and that the Kiddie Tax is applied once the unearned income exceeds the applicable threshold. This includes correctly completing IRS Form 8615, which is required when the Kiddie Tax applies.

By avoiding these common mistakes and ensuring accurate calculations, families can stay compliant with the Kiddie Tax rules and minimize their tax liabilities.

Conclusion

Summary of Key Takeaways on Calculating Tax on a Child’s Unearned Income

Calculating the tax on a child’s unearned income requires an understanding of the Kiddie Tax rules, which ensure that unearned income above a certain threshold is taxed at the parents’ higher marginal tax rate. The key steps in this process include:

• Identifying all sources of the child’s unearned income, such as interest, dividends, and capital gains.
• Determining if the Kiddie Tax applies based on the child’s age, filing status, and income levels.
• Calculating the tax by first applying the child’s standard deduction, then taxing income up to $2,500 at the child’s rate, and taxing any unearned income above $2,500 at the parent’s tax rate.
• Ensuring proper reporting of the child’s income on tax returns, including the use of IRS Form 8615 for unearned income subject to the Kiddie Tax.

Tax professionals and parents must also be mindful of specific scenarios, such as when a child has both earned and unearned income, capital gains from investments, or the potential benefits of using tax-advantaged accounts like 529 plans.

Importance of Careful Tax Planning for Families with Children Who Have Investment Income

Careful tax planning is essential for families with children who generate significant unearned income from investments. By using strategies such as timing the realization of capital gains, utilizing tax-advantaged accounts, and employing gift tax strategies, families can minimize the impact of the Kiddie Tax and reduce their overall tax liability.

Proper tax planning helps ensure compliance with tax laws while also taking advantage of opportunities to reduce tax burdens. Families with children who hold investments should regularly review their tax positions to avoid common pitfalls, such as underreporting income or incorrectly applying tax brackets. Ultimately, staying informed and proactive about the Kiddie Tax rules can lead to better financial outcomes for both the child and the family as a whole.