Kiddie Tax

The Kiddie Tax is a special tax rule created by the Internal Revenue Service (IRS) in the United States. Its main purpose is to prevent wealthy families from avoiding taxes by shifting large amounts of investment income to their children, who would typically be in a much lower tax bracket. In essence, it taxes a child's significant unearned income—money they didn't work for, like dividends or capital gains—at their parents' higher marginal tax rate instead of their own. Think of it as Uncle Sam's way of ensuring that a family's investment wealth is taxed at the family's rate, regardless of whose name is on the account. While it sounds a bit like a fun-spoiler, it's a critical concept for any value investor looking to build a nest egg for their children or grandchildren, as understanding it is key to making tax-efficient investment decisions for minors.

At its core, the rule is straightforward: if a child has too much unearned income, the taxman looks to the parents' income to figure out the bill. But as with any tax rule, the devil is in the details.

The Kiddie Tax doesn't apply to every child. It generally targets children and young adults who are still dependents. As of the latest regulations, the tax applies if the child meets any of these conditions:

• They are under age 18 at the end of the tax year.
• They are age 18, and their earned income (from a job, for example) does not provide more than half of their own support.
• They are a full-time student between ages 19 and 23, and their earned income does not provide more than half of their own support.

Once a child provides more than half of their own financial support with earned income or turns 24, they're free from the Kiddie Tax, and all their income is taxed at their own individual rate.

The Kiddie Tax only kicks in after a child's unearned income crosses a specific threshold. These numbers are adjusted for inflation, but let's use the 2024 figures to see how it works. Imagine a child has only unearned income from an investment account.

1. The First $1,300: This portion is completely tax-free, shielded by the child's standard deduction.
2. The Next $1,300: This slice is taxed at the child's own marginal tax rate, which is typically a very low 10%.
3. Anything Above $2,600: This is the part that gets “kiddie taxed.” All unearned income above this amount is taxed at the parents' top marginal tax rate, which could be 24%, 35%, or even higher.

Example: Little Leo, age 12, has a custodial account that generated $5,000 in dividends and capital gains this year.

• $1,300 is tax-free.
• $1,300 is taxed at Leo's rate (10%), resulting in a tax of $130 ($1,300 x 0.10).
• The remaining $2,400 ($5,000 - $2,600) is taxed at his parents' marginal rate. If his parents are in the 24% bracket, the tax on this portion is $576 ($2,400 x 0.24).
• Total Tax: $130 + $576 = $706.

Without the Kiddie Tax, that entire $5,000 (minus the standard deduction) would likely be taxed at the child's low rate, resulting in a much smaller bill.

So, the Kiddie Tax exists. How does a savvy investor work with it, not against it? The goal isn't tax evasion but smart, tax-efficient planning. This is where a value investor's long-term perspective is a huge advantage.

• Prioritize Long-Term Growth Over Income: Instead of buying stocks that pay high annual dividends or bonds that generate taxable interest each year, consider focusing on high-quality growth companies. The goal is to generate long-term capital gains that are only realized (and thus taxed) when the stock is sold, hopefully many years down the line when the “kiddie” is an adult and no longer subject to the tax. This perfectly aligns with the value investing principle of buying and holding great businesses.
• Use Tax-Advantaged Accounts: The Kiddie Tax primarily applies to taxable brokerage accounts, like those set up under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). To sidestep it, prioritize funding tax-sheltered accounts first.
  1. 529 Plan: Contributions grow tax-deferred, and withdrawals are tax-free when used for qualified education expenses. This is a powerful tool for college savings.
  2. Coverdell ESA: Similar to a 529, but with lower contribution limits and more flexible investment options.
  3. Roth IRA for Kids: If your child has earned income (from a summer job, for example), you can open a Roth IRA for them. Contributions grow and can be withdrawn completely tax-free in retirement. It's one of the best wealth-building gifts you can give a child.
• Be Mindful of Rule Changes: Tax law is never set in stone. The Tax Cuts and Jobs Act (TCJA) of 2017 temporarily changed the Kiddie Tax to be based on trust fund tax rates, which were often harsher. Later, the SECURE Act changed it back to the parents' rates. This history is a reminder to review your strategy periodically.

The Kiddie Tax is not a penalty for teaching your children about investing. It's a “fairness” rule designed to prevent a major tax loophole. For the value investor, it's simply another variable in the equation. By prioritizing long-term growth, utilizing tax-advantaged accounts like 529s and Roth IRAs, and strategically managing when investment gains are realized, you can build substantial wealth for your children while minimizing the tax bite along the way.