Understanding Unearned Income for a Child: The Kiddie Tax Explained

Young investors today have exciting opportunities to grow their wealth early, but they also face a unique tax challenge that many families don’t understand. When a child earns money from investments—like interest, dividends, or capital gains—that income falls under a special tax category with its own rules. Understanding what unearned income for a child means and how it’s taxed is essential for parents and guardians planning to help their kids build financial independence.

The U.S. tax system includes a provision specifically designed to prevent high-income families from using children as investment vehicles to reduce taxes. This is where the kiddie tax comes in. By learning about this tax rule now, you can make smarter decisions about how to structure your child’s investments and potentially save thousands in taxes over their lifetime.

What Counts as Unearned Income for a Child?

The term unearned income for a child refers to any money a child receives that isn’t earned through work or employment. This is distinct from wages, salary, or other compensation for actual labor performed.

Common types of unearned income for a child include:

• Interest income - Earnings from savings accounts, bonds, and other debt instruments
• Dividend income - Distributions from stocks and mutual funds
• Capital gains - Profits from selling investments at a higher price than purchase
• Trust distributions - Income received as a beneficiary of a trust
• Rental or royalty income - Earnings from property or intellectual property
• Taxable scholarships - Educational grants not used for qualified expenses
• Social Security benefits - Certain types of government benefits

An important distinction: If a child deposits earnings from their summer job into a savings account, the interest that account generates is considered unearned income, even though the initial deposit came from earned income.

Similarly, gifts and inheritances that generate investment income are treated as unearned income for a child. This includes money given under the Uniform Transfers to Minors Act (UTMA) or similar custodial arrangements.

Who Pays the Kiddie Tax and When?

Not every child with unearned income pays the kiddie tax. Several conditions must be met simultaneously:

Age Requirements: The child must fall into one of these categories:

• 17 years old or younger at the end of the tax year
• Exactly 18 years old with earned income representing less than half of their support
• A full-time student between 19 and 23 years old whose earned income is less than half of their support

Income Threshold: For the 2023 tax year, the kiddie tax applies when unearned income exceeds $2,500 (compared to $2,300 in 2022). This threshold adjusts annually for inflation.

Family Status: At least one parent must be alive at year’s end, and the child cannot file a jointly married return.

Filing Requirement: The child must be required to file a tax return based on their income level.

The kiddie tax wasn’t always part of the tax code. It was introduced through the Tax Reform Act of 1986 to close a loophole. Previously, wealthy parents routinely transferred investments into their children’s names, allowing all earnings to be taxed at the child’s typically lower tax rate. The kiddie tax rules prevent this strategy by applying the parent’s marginal tax rate to unearned income above the threshold.

How Tax on a Child’s Unearned Income Is Calculated

Understanding the actual tax calculation helps demystify how much tax your child might owe. The calculation uses a tiered system based on income thresholds.

The Three-Tier Tax Structure (using 2023 as an example):

The first tier protects the child through their standard deduction. The first $1,250 of unearned income for a child is entirely tax-free. This amount reflects the basic standard deduction for dependent children with no earned income.

The second tier represents a transition zone. The next $1,250 of unearned income (from $1,251 to $2,500) is taxed at the child’s own tax rate, which is typically lower than their parents’ rate. For a child with minimal other income, this might be the 10% federal bracket.

The third tier applies the kiddie tax. Any unearned income for a child exceeding $2,500 is taxed at their parents’ marginal tax rate. This is where the tax burden increases significantly.

Working Through a Real Example:

Consider a 16-year-old named Emma who is claimed as a dependent on her parents’ joint return. Her 2023 income includes:

• $200 of interest from a savings account
• $3,800 of dividend income from an investment account her parents opened for her
• $1,500 of capital gains distributions from her grandparents’ gift
• $6,200 in wages from part-time work

Emma’s total unearned income is $5,500. Adding her earned income of $6,200 and subtracting her standard deduction of $6,600 results in $5,100 of taxable income.

Breaking down the tax calculation:

• First $1,250 of unearned income: $0 tax (protected by standard deduction)
• Next $1,250 of unearned income: taxed at 10% rate = $125 tax
• Remaining $3,000 of unearned income: taxed at parents’ 24% rate = $720 tax
• Total tax on unearned income: $845

If the entire $5,500 of unearned income had been taxed at Emma’s personal 10% rate, the tax would only be $550. The kiddie tax results in an additional $295 in federal taxes.

Important Documentation: When the kiddie tax applies, parents must file IRS Form 8615 (Tax for Certain Children Who Have Unearned Income) with the child’s tax return. This form documents the calculation and justifies the parent’s rate application.

Strategic Options When Reporting a Child’s Unearned Income

Parents have flexibility in how to handle their child’s income reporting in certain situations. If your child has only interest and dividend income (including capital gain distributions), you can elect to report all of the child’s unearned income directly on your own tax return instead of the child filing separately.

This approach requires filing Form 8814 and has several advantages:

• Eliminates the need for the child to file their own return
• Bypasses the kiddie tax calculation entirely
• Simplifies your overall tax filing

However, this option only works when the child has purely investment income with no other income sources. If the child has any earned income from employment, this option becomes unavailable.

Additional Taxes Beyond the Kiddie Tax

Some families face yet another layer of taxation: the net investment income tax. This 3.8% surtax applies when modified adjusted gross income exceeds certain thresholds:

• $200,000 for single filers and heads of household
• $250,000 for married couples filing jointly
• $125,000 for married couples filing separately

The net investment income tax applies to interest, dividends, capital gains, rental income, and royalties. It does not apply to wages or employment-related income. Calculating this tax requires completing Form 8960.

Smart Ways to Minimize Tax on a Child’s Unearned Income

Rather than accepting heavy tax burden on your child’s investments, consider these strategic alternatives:

Tax-Advantaged Accounts: Using 529 education savings plans or custodial IRAs is one of the most effective approaches. These accounts allow investments to grow tax-free, and with proper planning, withdrawals can also be tax-free. Unlike traditional custodial accounts (like UTMA accounts), these specialized accounts don’t trigger the kiddie tax at all because they don’t generate unearned income that’s reportable to the child.

Roth IRA Strategy: A child with earned income can contribute to a Roth IRA, allowing their wages to grow tax-free and sheltered from the kiddie tax entirely.

529 Plan Advantages: These plans offer dual benefits—tax-free growth and tax-free withdrawals for qualified education expenses. Some states even offer state income tax deductions for contributions.

Income Timing: Consider the timing of income realization. Deferring capital gains sales until the child reaches age 18 (or becomes a student past age 23) removes them from the kiddie tax rules entirely.

Direct Contributions: When making gifts to children, consider contributing directly to tax-advantaged accounts rather than letting money sit in taxable investment accounts.

The bottom line: Understanding what unearned income for a child represents and how the kiddie tax works gives you the knowledge to structure your family’s investments strategically. By utilizing tax-free accounts and proper planning, you can help your child build wealth without unnecessary tax consequences.