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THE "KIDDIE TAX"

        The "Kiddie" Tax         

For our clients that have children under the age of 18 (or 24 for full-time students) earning interest and dividends, we often are faced with a choice of how to report that investment income.  

We can  either include the income on the parent's return or file a separate return for the child.

The decision isn't always clear-cut.  Reporting the income on the parent's return can sometimes result in a higher tax bill, but filing an additional return especially for the child or children will usually result in a higher tax preparation fee.

We can  either include the income on the parent's return or file a separate return for the child.

 

Whichever method you choose, the first $1,000 of the child's investment income will be tax-free and the next $1,000 will be taxed at the child's 5% or 10% tax rate depending on earned income. Additional income is taxed at the parents' rate, which may be a lot higher than 10%.

However, the "kiddie tax" that results from reporting the child's income on a parent's return can indirectly result in a higher family tax burden.

The reason is that if your child's income exceeds $2,000, any excess will increase your "adjusted gross income," which in turn can reduce some of your tax benefits. The size of certain tax benefits is tied to your adjusted gross income. Generally, the higher your income, the smaller your write-offs. 

Among the tax benefits at risk are write-offs for medical and "miscellaneous" itemized expenses, Individual Retirement Account deductions and the child-care credit. The list grows longer for higher-income parents who are subject to automatic reductions in most itemized deductions and a phaseout of personal exemptions as their income rises.

On the other hand, reporting the child's income on a parent's return can increase the amount of investment interest expense that the parent can write off and raise the deductible ceiling on large charitable contributions. But relatively few people will find those advantages outweighing the disadvantages of including the child's income on their own return.

Nevertheless, filing a separate return for the child may not be the most economical option either. We know from experience that it takes time for both the preparation and the internal processing of an additional tax return in our office to prepare a special return for your child.  Rest assured, however that we do attempt to make the best decision for our clients in each individual situation.  

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