Dollars and Sense

We all know that everyone has to file a tax return and pay their taxes due, but does that apply to children too? Many people may have heard of what is often referred to as the “kiddie tax,” but do you know what it may mean for your own family’s tax planning?

Tax rules for dependents’ income

The Internal Revenue Service has special rules for children and any other dependents claimed on another taxpayer’s tax re­turn. (In addition to children, the definition of dependents might also in­clude older relatives who are under or over 65.) Some of those rules apply to earned income, which is money a child might make at a summer or afterschool job, for example. If your child earned $5,800 or less in 2013 and is claimed as a dependent on your return, then he or she does not have to pay tax on that income. If he or she earned more than $5,800 last year, then he or she will have to file a return and potentially pay income tax. (Your child is eligible to take business or charitable deductions that may lower his or her taxable income.) There are also special rules for dependents who are married, over 65 or blind, so talk to your CPA if your dependents fall into these categories.

Defining unearned income

Dependents may also have to pay tax on unearned income, which would include dividends, interest and capital gains. This tax was introduced to prevent parents from shifting some of their investment income to their children in order to avoid paying tax on it. If your child had no more than $950 in investment income in 2013, then he or she does not have to file a return or pay tax on that income. Once again, there are also special rules for dependents who are married, over 65 or blind.

Taxing unearned income

The rules become a little more complicated, however, if your child had unearned income over $950. While the first $950 is tax free, the second $950 of income is taxed at the child’s presumably low income tax rate. Any income of more than $1,900 is taxed at the parents’ marginal tax rate. That remains the case until the child hits 19, at which point he or she is no longer subject to the parents’ high tax rates. However, the child may be subject to the kiddie tax up until the age of 23 if he or she is a full-time student. It may be possible to avoid filing a separate return for the child if the parents decide to include the child’s unearned income on their return and that income comes to a total of less than $9,500.

Before taking this step, check to see if adding their income to your return will push you into a higher tax bracket. What happens if a child has both earned and unearned income? In this case, it may be necessary to file a return and pay taxes depending on the separate and total income levels involved. Consult IRS Publication 929 for more details.

College planning and the kiddie tax

Many people consider setting up a college savings account in their child’s name. The kiddie tax is one reason why it’s a better idea for the parents to open a tax-advantaged option-such as a 529 savings plan or Coverdell plan. The money you earn on deposits in these accounts is tax free as long as the account proceeds are used for qualified education expenses. That means you don’t have to worry about related taxes — kiddie or otherwise.

Dollars & Sense is a monthly column provided by the Oregon Society of CPAs