Financial education for the young may come with a cost to their parents—the kiddie tax.
Over the last year or so, companies like Fidelity and Greenlight have launched investment platforms aimed at teaching children about money, allowing them to research financial products and invest. Sounds great, except if they are too good at investing, the tax collector may come calling after their unearned income hits a certain threshold.
- Companies are aiming to educate kids about finances with new investment platforms, but these could end up generating higher tax bills for families.
- Children’s unearned income could be subject to taxes.
- The first $1,100 of their unearned income is tax-free, the next $1,100 is taxed at a children’s rate, and anything above $2,200 is subject to the “kiddie tax.”
But how much could a tax on a child’s unearned income—interest, dividends, and capital gains, not wages—really amount to for the tax collector? Turns out, quite a bit. In tax year 2018, the IRS said about 415,000 taxpayers (or roughly 0.27% of all filers) attached form 8615, used to calculate the tax for unearned children’s income. The total bill: $1.095 billion in taxes. And, since that was before the recent advent of more investment platforms aimed at kids, that amount of revenue is likely to grow in the years ahead.
A tax on unearned income generated by children—the kiddie tax—was first enacted as part of the Tax Reform Act of 1986 to prevent wealthy parents from reducing their own tax liability with investment accounts and trusts in the names of their children up to age 14, who would typically be subject to lower tax rates. Over the years the kiddie tax has gone through many iterations, with a child’s unearned income taxed at different rates and at various threshold amounts.
Currently, kids under age 19 by the end of the tax year get their first $1,100 in unearned income tax-free. The next $1,100 is taxed at the children’s rate of 10%, but anything above $2,200 gets taxed at their parents’ individual rate, if the parents’ rate is higher than their child’s. Children who are 19 to 23 years old and are full-time students can also be subject to the kiddie tax. In some cases, parents can choose to include the income on their own tax returns instead of filing a separate return for their kids.
Beware Other Taxes, Too
There may be additional taxes as well. Fidelity, which recently launched a youth account for 13- to 17-year-olds, warned parents that funds used to open the account may be subject to gift taxes if they come from the parent/guardian or other third party. For tax years 2018 through 2021, any amount more than $15,000 would be taxed as a gift.
Since the additional income is reported to the IRS, there could be further consequences if the child applies for student financial aid. Federal student aid is partly determined using the family’s taxed and untaxed income, assets, and benefits.
Fidelity urges parents to consult a tax advisor about the potential federal, state, and local tax consequences of its youth account. In the end, though, the experience can pay off for kids as they grow into financially responsible adults.
“This can be confusing—but if you use a tax expert, you will minimize your headache at tax time,” said Jo Willetts, director of tax resources at Jackson Hewitt, in an email. “Honestly, teaching your children about saving and investing is worth the small amount in taxes it may cost you.”