Kids can't vote. As if that wasn't already obvious, Congress really drove the point home in the 1986 Tax Reform Act with the creation of the so-called "kiddie tax." In spite of the rules having been around for a few years, many are still confused on this legislation.
The Kiddie Tax only applies to children under the age of 14. If your child reaches age 14 before the end of the calendar year, the tax does not apply for the entire year. Children over 14 are taxed, for the most part, like adults. The tax also applies only to "net unearned income." Net unearned income consists of taxable interest, dividends, capital gains, pension distributions, the taxable portion of social security benefits and taxable distributions from trusts. Earned income (e.g. paper route) is not subject to the special tax rules.
In 2002, the first $750 of net unearned income is not taxed. The next $750 is taxed at the child's rate (most likely 10%). Net unearned income over $1,500 is taxed at the higher of the parent's rate or the child's rate. Clearly, the parent's rate will be the one that most frequently applies. The rate could be as high as 38.6%. If parents have more than one child under 14, the incomes of all are aggregated for purposes of calculating the tax at the parent's rate. The tax is then allocated between the children based on their incomes. Since the children's incomes are aggregated, the tax at the parent's rate can be pushed into the 30% marginal bracket or higher. Had the children's incomes been considered separately, this may not have happened.
Ordinarily, children file their own returns and attach Form 8615. By the way, just to show you that the IRS does have a sense of humor, the Service maintains that it takes only 55 minutes to prepare the form. Yeah, right.
Parents will have an election to include their children's unearned net income on their return. The election is made on Form 8814. To qualify, the following must be present: 1) the child must be under age 14, 2) the child's income must be solely from interest and dividends (mutual fund capital gain dividends qualify), 3) the child's income must be more than $500 and less than $4,700, 4) the child must not have made estimated tax payments, been subject to back-up withholding nor applied a prior year's overpayment to current year taxes. The election may be made on the joint return of the parents. If the parents file separately, the election can only be made by the higher income parent.
For most parents, it probably makes more sense to file a separate return for the kids. Due to a quirk in the rules, those who file Form 8814 only receive a $500 exemption instead of a $750 exemption for each child. Also, including the child's income will drive up the parent's adjusted gross income, making it less likely Mom and Dad will qualify for certain deductions and perhaps triggering certain deduction and exemption phase-outs. On the other hand, some parents may benefit from additional investment income if they have large investment interest expenses or from the child's capital gains if they have losses.
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