Kiddie Tax for Dependents - 18 and Under

The Kiddie Tax rules provide that investment income in excess of $1,900 (for 2009) will be taxed at the higher of the parent's rate or the child's rate. For this purpose, investment income is income other than earned income. However, income splitting can still save your family money.

There are 3 key issues to keep in mind when deciding how much investment income you want to give your child:

The Kiddie Tax applies to unmarried children younger than 18, to children age 18 whose earned income is not more than half their support and to children older than 18but younger than age 24 who are full-time students and whose earned income is not more than half their support.

Your child's earned income from jobs or self-employment is not subject to these rules.

The Kiddie Tax affects only unearned income in excess of an annual threshold ($1,900 for 2009).

In other words, your child can have up to $33,950 of taxable income for 2009 (earned and/or unearned) and pay tax at the 10% or 15% (or 0% on long-term capital gains and qualified dividends — this rate is 5% beginning after 2010) rates.

Investment Options

Because the Kiddie Tax disappears after a child turns 24, consider giving your kids investments that defer income until the Kiddie Tax no longer applies. U.S. savings bonds can be a good choice because income can be deferred until the bond is cashed. If the bond is cashed after the Kiddie Tax no longer applies, the interest that accrued up to that time is taxed at the child's own rate.

However, it may be better to buy the bonds in your name and cash them when your child begins college. If your income is below the limit for the year you cash in the bonds, you can exclude the interest if the amount you redeem is not more than the qualified education expenses for the year.

Stocks are another way around the Kiddie Tax. As the stock appreciates, there's no tax on the paper profit. If the stock is sold after the Kiddie Tax no longer applies, the profit is taxed at the child's rate.

Note: if a child invests in stock mutual funds, rather than individual stocks, the fund may pay out capital-gain distributions each year based on gains recognized by the fund. Such income would be subject to the Kiddie Tax if the child's unearned income exceeds $1,900 for 2009.

For income splitting to work, the child must actually own the assets that generate the income. If you want your son to pay tax at his rate on $1,000 of interest income generated by a $25,000 savings account, you can't simply give him the $1,000. You must give him the $25,000 in the account. Only then will the income it produces be his for tax purposes.

Custodial Accounts

The easiest way to make such a gift to a minor child is to set up a custodial account under your state's Uniform Gift to Minors Act or Uniform Transfer to Minors Act. Banks, savings & loans, credit unions, mutual funds and brokerage firms offer such accounts. All you need is a social security number for the child and a custodian to manage the account until the minor comes of age. You can name yourself custodian, but if you are also the donor and you die before the child reaches maturity, the gift will be considered part of your estate for federal estate-tax purposes.

An important point about custodial accounts is that your gift is irrevocable — you can't get it back. Once the child becomes an adult under your state's law — usually at age 18 or 21 — adult supervision of the account ends and the child can do anything he or she wants with the money.

You don't need a custodial account if you invest the child's money in U.S. savings bonds. Just buy the bonds in the child's name. Don't name yourself co-owner, though, or the income will be taxed to you when the bonds are cashed.