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  The Kiddie Tax

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For our clients that have children under the age of 18 earning interest and dividends, we often are faced with a choice of how to report that investment income.  

If the child's income consists only of investment income and is less than $10.500 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.

Whichever method you choose, the first $1,050 (in 2016) of the child's investment income will be tax-free and the next $1,050 will be taxed at the child's low tax rate. Additional income is taxed at the parents' rate, which is generally a lot higher.

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 $2,100, 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 phase-out of personal exemptions as their income rises.

Many of the valuable tax breaks including the child tax credit and the college tuition credits are phased out for taxpayers with adjusted gross incomes above certain levels.

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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