One of the less heralded aspects of the Tax Cuts and Jobs Act (TCJA) was the change in how you calculate the “Tax for Certain Children Who Have Unearned Income”, otherwise known as the Kiddie Tax. This alternative tax calculation was put in place back in 1986 in an effort to prevent wealthy taxpayers from shifting investment assets to their children, where the investment income would be subject to a lower tax rate. This calculation is just one of the many reasons why preparing tax returns for children can often be more complicated and time consuming than you’d think!
In 2018, the kiddie tax applied to children who reported unearned income above $2,100 and who met any of these age requirements:
Under the age of 18 at the end of the year
18 years of age at the end of the year, but whose earned income did not exceed half the cost of their annual support
19-23 years of age at the end of the year, who are full-time students and whose earned income did not exceed half the cost of their annual support.
Unearned income is essentially any income that is not wages, salaries or self-employment income. The unearned income that we most commonly see subject to the kiddie tax is investment income such as interest, dividends and capital gains. However, other types of income, like IRA distributions, rental income and pension income, are also considered unearned income and could be subject to the kiddie tax.
Prior to the TCJA, the kiddie tax was calculated by applying the parent’s tax rate to the child’s unearned income, then comparing that to the child’s own tax calculation without the kiddie tax. It can be thought of as a kind of alternative tax calculation, similar to the Alternative Minimum Tax (AMT). Like the AMT, this was a complex calculation with many moving parts, and the AICPA advocated for a simpler kiddie tax as Congress was crafting the TCJA.
Under the new law, for the years 2018-2025 when it is currently set to be in existence, the kiddie tax will be a simpler calculation. Rather than applying the parent’s tax rate to the child’s unearned income, that income is now subject to the tax brackets and rates that apply to trusts and estates. There are still some complexities involved in the calculation, and the net impact will vary greatly depending on one’s circumstances.
The trust income tax brackets are much more “compressed” than the individual income tax brackets. This means you hit the top tax brackets at much lower levels of income for trusts than you do for individuals. For example, you would be in the top ordinary tax bracket of 37% at just $12,501 of income for trusts, whereas you wouldn’t hit that tax bracket if you are married filing jointly (MFJ) until you reach $600,001 of income. Here’s a comparison of the MFJ brackets to the trust bracket:
Married Filing Joint
Trusts & Estates
The same compression of rates applies to long-term capital gains and qualified dividends
Married Filing Joint
Trusts and Estates
On first glance, it might look like everyone would be hurt by the new calculation, since you need a lower level of income to hit the higher tax rates. However, the actual impact could be positive or negative, and will depend largely on the type of income the child has and the tax bracket of their parents.
As a simple example, if a child’s parents are in the top tax bracket, their unearned income under the old rules would all be taxed at their parents’ marginal tax rate. However, under the new rules, the tax is calculated using the progressive rates of trusts and estates. That means some of their income will be taxed at the lower marginal rates, even if their income is high enough that they wind up paying tax on some of that income at the highest tax rate.
On the flip side, children in some situations could see a much higher kiddie tax rate. For example, dependents of military service members who died while in active duty are eligible to receive survivor benefit plan (SBP) distributions. Often the parents of these children are not in high tax brackets, so under the old rules, the kiddie tax did not have a major impact on the taxation of this unearned income. However, that income is now subject to the compressed trust and estate tax rates.
This situation raised the attention of lawmakers, and the House included a repeal of the new kiddie tax rules in the SECURE Act, which was passed in May. The Senate has not yet taken that bill up for a vote, but they separately passed a different bill, the Gold Star Family Tax Relief Act, which would have treated survivor benefits as earned income so it wouldn’t be subject to the new kiddie tax rules. Neither bill has been passed into law yet, though there is unanimous support from both sides.
Survivor benefits aren’t the only area where we see unintended consequences from the kiddie tax. Scholarship proceeds used for expenses other than qualified tuition and related expenses are generally included in income and considered to be unearned income, making them subject to the kiddie tax rules as well. This is an area where we saw quite a few children this tax season who were facing higher tax liabilities as a result of the changes in the kiddie tax.
If you have children who have been subject to the kiddie tax in the past, or who you think might be subject to it in the future, the best way to assess the impact of the change is to run the numbers. The facts and circumstances of each situation need to be assessed to determine whether the new rules positively or negatively impact you, and whether you can implement any planning techniques to offset the impact. It’s important to keep in mind that these changes could go away if the SECURE Act or something similar is passed by Congress. If you have specific questions regarding your situation, we’d be happy to discuss this with you and to run calculations for you.
-Chris Benson, CPA/PFS
The views expressed represent the opinions of L.K. Benson & Company and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person. Please see Additional Disclosures more information.
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