If your children have investment income, watch out for the so-called “kiddie” tax. It taxes all but a small portion of a child’s unearned income — such as dividends, capital gains and interest — at his or her parents’ marginal tax rate. The kiddie tax is designed to prevent parents from lowering the family’s tax bill by transferring income-producing assets to children in lower tax brackets.

How It Works

Generally, the kiddie tax applies to all children age 18 or younger, as well as to full-time students who are between 19 to 23 years old. There are a couple of exceptions: To avoid the tax, the child must either provide over half of his/her support from his/her own earned income (i.e., wages and other payments for work) or be married and file jointly with his/her spouse. Be sure to note that the support test for the kiddie tax is different from that for claiming personal exemptions.

For 2016, if the kiddie tax applies, the first $1,050 of a child’s unearned income is tax-free, and the next $1,050 is taxed at the child’s rate. Then, any unearned income above $2,100 is taxed at the parents’ marginal rate. (These thresholds are adjusted annually for inflation.)

Planning Opportunities

Although the kiddie tax makes it harder to shift income to your children, there are still some planning opportunities. Keep in mind, however, that while transferring assets to your children can sometimes save taxes, it can also affect their eligibility for need-based financial aid. Why? Because colleges give more weight to assets in the child’s name when determining need.

Often, the best way to minimize the kiddie tax is for your children to avoid investments that generate taxable income. You can shield your child’s savings from your higher tax rates by using vehicles, such as Roth IRAs and Section 529 college savings plans, that offer tax-free earnings and withdrawals. An added benefit of Sec. 529 plans is that they’re generally treated as the parents’ asset for financial aid purposes.

Reporting Issues

Income subject to the kiddie tax can be reported on your child’s tax return or, if certain requirements are met, on your return. Generally, reporting it on your child’s return is preferable. Although the amount of kiddie tax itself is the same under either option, including additional income on the parents’ return might reduce deductions or credits that are phased out above certain income levels.

Another consideration is the 3.8% net investment income tax (NIIT). Higher income individuals subject to the NIIT may benefit from shifting income to and having their child claim investment income on the child’s tax return, because the child receives his or her own $200,000 exclusion from the NIIT.

Got Kids?

If your children own investments or other assets that generate unearned income, a member of our private client services team can help address the kiddie tax and lower your family’s combined tax bill.