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  • Writer's pictureHannah Boundy, CFA®, CFP®

The Origins of the Kiddie Tax and 3 Ways to Invest (Tax-Efficiently) for Your Kids  

In 1986, Congress passed a new tax law which created the “kiddie tax” in response to parents who were transferring excessive amounts of unearned income to their children who were previously taxed at a lower rate. The intent was to ensure that any unearned income would not escape taxation despite being transferred.  


Today, this means that children under the age of 18 and full-time students under the age of 24 pay taxes at the same marginal rate as their parents. It’s important to understand that earned and unearned income are considered differently when it comes to the kiddie tax. Earned income is taxed at the child’s tax rate, but the limited standard deduction applies, which is equal to the greater of $1,300 or their earned income plus $450 up to the maximum standard deduction of $14,600. This means that if your teenager is working a summer job, their first $14,600 of earned income will be effectively tax-free. Any income earned beyond that will be taxed at the child tax rate. 


When it comes to unearned income - income not earned from working but from other activities such as investing – different rules apply. The standard deduction covers the first $1,300 of unearned income, and the next $1,300 is taxed at the child tax rate. Any unearned income beyond that $2,600 sum is now taxed at the parent’s tax rate.  If your son Tommy has $5,000 of income on his stock portfolio, he’ll apply your tax rate to $2,400 of it (and his own on the other $2,600).  


It’s clear that trying to pass off unearned income to your kids to take advantage of their lower tax rates isn’t a winning strategy – and hasn’t been since 1986. Nevertheless, there are still a few great ways to help invest for and in your kids in a tax-efficient manner.


1.) Invest for their future career 

The topic of saving for college has gained a lot of attention in recent years, particularly as both the costs of higher education and the balance of student debt continue to soar. That said, there is also still value to education, specifically in industries where certain skills and knowledge are key to advancement. If your child has an aptitude for learning and education is a value you’d like to pursue, college savings accounts remain a tax-friendly way to save for their future. Furthermore, recent legislation has enhanced the flexibility of these accounts, making it possible to use some of the funds on a broader range of costs as well as convert a portion of unused funds to a retirement account if college doesn’t work out for your child. You can learn more about these accounts by checking out this article written by my colleague a few years back: How to Find the Right College Savings Plan for your Family: 529 vs. Coverdell ESA. 

 

2.) Invest in their retirement 

If Tommy is earning good money at his summer job, you may want to consider opening a Custodial Roth IRA for him. While his contributions are limited to his earned income (or the $7,000 limit – whichever is higher), the balance will grow tax-free forever – which is a pretty long time for those returns to compound. Because the account is owned by Tommy, it also is a moot point if his parents earn over the income threshold for contributing to a Roth, which is great news if both of his parents are high earners. (Tommy will, however, need to file his own taxes reporting his own earned income to ensure his eligibility. As always, it’s a good idea to confer with a tax professional when executing tax strategies). 

 

3.) Invest in their well-being 

At a certain age, financial literacy becomes a really great topic of learning for kids and we highly encourage teaching personal financial literacy through doing. Whether it’s opening a Custodial Roth IRA for your working teenager, setting up an UGMA or UTMA (you can learn more about custodial accounts here), or letting your kids save into their own brokerage account that you fund with a nominal amount of money, your kids can learn a lot about saving and investing by actively engaging with their money. My own husband began saving and investing in the stock market at the ripe age of 13 after reading a book on investing that piqued his interest. By the time he graduated college, he had accumulated a down payment all because he had worked hard, saved, and invested (though this is the part where I remind you that there are no guarantees when it comes to investing). Along the way, he had some really great conversations with a beloved Uncle about personal finances and saving that continue to influence him today.  


While everybody has to pay taxes – even kids – there are some great ways to not only save for your child’s future but engage with them on the topic. If you’d like to talk more about setting up one of these accounts or are looking for resources on how to teach your kids about financial literacy, please don’t hesitate to reach out. We’d love to chat about the topic further! 


 

Sources 

Chairman Grassley’s Finance Committee Staff. (2006, May 23). The real effect of the “Kiddie Tax” Change: The United States Senate Committee on Finance. United States Senate Committee On Finance. https://www.finance.senate.gov/chairmans-news/the-real-effect-of-the-kiddie-tax-change 


 

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