Legal Definitions - kiddie tax

The "kiddie tax" is a specific provision within tax law designed to prevent individuals from reducing their overall tax burden by transferring income-generating assets to their minor children. Under this rule, a portion of a child's unearned income—such as interest, dividends, or capital gains—that exceeds a certain threshold is taxed at the parents' marginal income tax rate, rather than the child's typically lower rate. This mechanism ensures that investment income earned by a child is taxed similarly to how it would be if the parents still owned the assets, thereby closing a potential loophole for tax avoidance.

Here are a few examples to illustrate how the kiddie tax applies:

• Example 1: Investment Income from an Inheritance

  Imagine a 10-year-old child who inherits $150,000 from a grandparent. This money is invested in a diversified portfolio that generates $6,000 in annual dividends and interest. Without the kiddie tax, this $6,000 would likely be taxed at the child's very low income tax rate, or even be fully offset by their standard deduction. However, because of the kiddie tax, any portion of that $6,000 that exceeds the annual unearned income threshold (which is adjusted for inflation each year) will be taxed at the parents' higher marginal income tax rate. This prevents the family from effectively sheltering investment income by having the child own the assets.

• Example 2: Capital Gains from Gifted Stock

  Consider a parent who gifts shares of a rapidly growing technology stock to their 16-year-old child. A few years later, the child decides to sell these shares, resulting in a $20,000 long-term capital gain. The kiddie tax would apply to the portion of this $20,000 gain that exceeds the unearned income threshold. Instead of being taxed at the child's potentially 0% or 10% long-term capital gains rate, the excess amount would be taxed at the parents' higher capital gains rate (which could be 15% or 20%, depending on their income). This ensures that the capital gain is taxed as if the parents had realized it themselves, aligning with the intent of the law to prevent tax avoidance through income shifting.