Understanding the Kiddie Tax

It's a tax, commonly referred to as the "Kiddie Tax," that is applied to your child's unearned income of more than $1,900. Unearned income refers to investments, such as interest, dividends and capital gains, not income from wages or self-employment.

The tax is meant to discourage parents from reducing their own taxes by shifting investments to their children, who generally have lower tax brackets.

The Kiddie Tax once affected only children under age 14. That's how it got its name.

But the Kiddie Tax has grown up and now can apply to investment income of children up to age 23 in certain circumstances.

Your child has investment income of more than $1,900 and falls into one of these categories:

• Under age 18 at the end of 2012 
• Age 18 at the end of 2012, with earned income (from working) that is less than or equal to half of their support for the year
• Full-time student age 19-23 at the end of 2012, with earned income (from working) that  is less than or equal to half their support

The tax kicks in only when your child’s investment income exceeds $1,900. The first $950 reported on your return is tax free, the second $950 is taxed at the child’s rate.

Unearned income above that amount is subject to the Kiddie Tax – that is, your marginal tax rate.  Marginal tax rate is the your highest rate, applied to the last dollar you earned. That could be as high as 28%, 33% or 35%.

You can pay the kiddie tax in either of two ways:

• Include your child's investment income on your tax return (using Form 8814) or,
• Have your child file a separate return (using Form 8615).

The tax on your child's income will be the same either way.

While the first option is more convenient, it could increase your taxable income and prevent you from taking certain deductions and credits, such as those for education.

With the second, your taxable income won't take a hit. Your tax rate will still be applied on the investment income reported on your child's return because your name and Social Security number will be listed on the child's return. If you file as married filing jointly, be sure to list the name and Social Security number of the parent whose name is first on the joint return.

The Kiddie Tax can get a bit complicated. But TurboTax will guide you through it, whether you include your child's investment income on your return or have your child file a separate return.

For more detailed information, see What is the Kiddie Tax and Do I have To Pay It?.