Posted by Fred Lake

New Kiddie Tax Rules: What You Should Know

New Kiddie Tax Rules: What You Should Know

Many parents, in a bid to secure their kid's financial future, do anything possible. It is understandable as the cost of college rises year in year out. Besides, only a few students get to qualify for a student loan. Parents understand this and try all in their capacity to save so their kids can have the necessary education. Many parents will set up an account in the name of the kid. This, however, can translate to unnecessary tax bills if you are not careful.

This is part of the reason Kiddie tax came up. The original intention was to stop some parents from using their kids to access an unfair tax advantage. In late 2017, the Kiddie tax was adjusted as part of broad tax reform. Recently as well, lawmakers came up with some regulations that affected the kiddie tax. As a result, parents need to get familiar with the laws guiding the kiddie tax. 

Kids as tax shelters

Many people understand that there is a difference in tax rates between parents and kids. Hence, before the kiddie tax came up, many parents used this opportunity to get a lower tax rate. They created investments in the name of their child. As a result, dividends from such investments will enjoy a pretty moderate (the child) tax rate.  

Also, quite a lot of children have little or no income. As a result, some investments will not be taxed at all. Besides, kids that have any form of income will enjoy a much lower tax rate compared to working-class adults with a reasonable income.

Part of the aim of the kiddie tax was to stop this unfair tax advantage. As a result, when a child’s income gets to a certain level, they will have to pay the parent's tax rate. If a child, however, earns from legitimate investment, such income will be spared. When any investment income, however, gets above a certain threshold, it will be taxed at the same rate a parent's investment will be taxed.

How does the Kiddie Tax work?

The kiddie’s tax applies to kids in these two categories:

    •    Dependent children within the age of 19 years 

    •    Full-time student between ages 19 and 23

There are, however, some exceptions to the Kiddie tax. A child with earned income that is above half the cost of their support will be exempted. Kids that file their tax returns as married filing jointly, for instance, will also be exempted. Also, the new kiddie tax does not affect money from tips, wages, salary, and self-employment. The following are unearned income of a child: 

    •    Dividends

    •    Taxable interests

    •    Capital gains

    •    Taxable scholarships

    •    Gift from grandparents 

A brief change to the Kiddie tax Rule 

For two years, there was a change to this rule in which a different system was used. The parents' tax rate was not used, but the tax rate for estates and trusts. The rates varied from 10% to 37%, resembling the tax rate for individuals and couples.

This change triggered two effects:

    •    Families that have high income which classified them in the top tax bracket were able to take advantage of the lower tax rate used by estate and trusts, even though the income was small.

    •    The sad part, however, is that scholarship money was also subject to the kiddie tax. With the compressed brackets, low-income earners have to be taxed high due to this regulation 

Congress Came with a Fix

In a bid to fix the second error, lawmakers came up with regulations that got the kiddie tax back to default – where it was before the tax reform. This is part of the SECURE Act changes, which will have taken effect from the beginning of the year 2020. 

The good news is that taxpayers could have the old rule apply to the years in which the new rule took effect – 2018 and 2019. This will benefit everyone because people who had the new rule work in their favor will keep their benefits, while those who were not so favored will have their issue solved.

This, however, could be a disadvantage for folks that use the kiddie tax changes to their advantage in the last two years. People that, however, paid the excess tax due to this change will be pleased that the government has corrected its wrong. 

Fred Lake
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