Were you caught by surprise when you found out that your almost adult child was subject to the Kiddie Tax?  You are not alone. Kiddie tax rules generally apply to children through the age of 18 and full-time students under the age of 24.

To prevent parents from placing investments in their children’s names to take advantage of the child’s lower tax rate, Congress several years back created what is referred to as the “Kiddie Tax”.  Under the Kiddie Tax, a child’s investment income in excess of $1,900 is taxed at the parent’s tax rate rather than the child’s.  These rules do not apply to married children who file a joint return with their spouse or self-supporting children.

Depending upon your circumstances, this can be either a tax return preparation nuisance or a penalty tax – or maybe both.  Many insightful parents seek tax-advantaged ways to put money aside for their children’s education, first home, etc.  They should not be deterred by the Kiddie tax, as there are legal ways to avoid it.  This is generally accomplished by making investments that produce tax-free income or that defer income until a year the child is no longer subject to the Kiddie Tax.  If, at that time, the child is in school or just starting in the work force with little or no other income, the deferred income could then be realized with little or no income tax.

The following are examples of investments that either defer income or generate tax-free income.  However, you must also consider that some of these might have a lower rate of return than a taxable investment and may not always be appropriate in the current economic climate:

  • U.S. savings bonds – Interest can be deferred until the bonds are cashed.
  • Municipal bonds – Generally produce tax-free interest income for Federal taxes.  Most states with a state income tax also permit tax-free treatment of interest from bonds of that state or local governments within that state.
  • Growth stocks – Stocks that focus more on capital appreciation than current income.  The child could wait to sell them until he or she is no longer subject to the Kiddie tax.
  • Mutual funds – Mutual funds that focus on growth stocks or municipal bonds.  Although they might throw off some taxable income, their primary goal is capital appreciation or tax-free income.
  • Unimproved real estate – That provides appreciation without current income.

If the family has a business, that family business could employ the child.  The child’s earned income is not subject to the Kiddie tax rules and will generate a deduction for the family business (assuming the wages are reasonable for work actually performed).  The child’s earned income can be offset by the standard deduction for a dependent, and the excess income will be taxed at the child’s rate (not the parent’s).  In addition, the child would also qualify for a Traditional or Roth IRA, which provides additional income shelter.

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