In 1986, Congress was so concerned about kids cheating the system (okay, really, kids and their parents), that they enacted the so-called “kiddie tax.” The idea behind the kiddie tax was that by taxing a child’s passive income (from, say, investments) at the same rate as that of their parents, there would be little to no incentive to shift income.

Whether or not a child must file a federal income tax return—and the rate at which the child pays tax—depends on whether it is earned income or unearned income. Earned income is income from wages, salary or self-employment; tips are also considered earned income. Unearned income is generally passive income like money earned from dividends and interest.

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In 1986, Congress was so concerned about kids cheating the system (okay, really, kids and their parents), that they enacted the so-called “kiddie tax.” The idea behind the kiddie tax was that by taxing a child’s passive income (from, say, investments) at the same rate as that of their parents, there would be little to no incentive to shift income.

Whether or not a child must file a federal income tax return—and the rate at which the child pays tax—depends on whether it is earned income or unearned income. Earned income is income from wages, salary or self-employment; tips are also considered earned income. Unearned income is generally passive income like money earned from dividends and interest.

Even if a child’s income is taxed at the child’s parents’ tax rate, that does not necessarily mean that the income has to be included on the parents’ tax return; the child can opt to file a separate return (and in fact, that can sometimes be preferable for all kinds of reasons, including the dreaded AMT).

That, of course, assumes that everything is easy. Sometimes, arrangements aren’t so clear-cut. In the event that the child’s parents are divorced, generally, the kiddie tax is reported on the custodial parent’s tax return. In the event that the child’s parents are unmarried—and have never been married to each other—or if the child’s parents are married but filing separate, the kiddie tax is calculated using the parent’s return with the highest taxable income.



Tips and Income for Kids (when your kids earn their own money)

Taxpayer asks:

My daughter worked as a bagger (bagged groceries) last year at our base commissary. The baggers do not receive a salary and work strickly for tips. I already checked with the “Head Bagger” at the commissary who said no type of 1099 will be sent. How do I go about claiming the monies my daughter earned? I also heard there is a set amount a child under 18 can make that is not taxable. Is this true? Thank you.

Taxgirl says:

First of all, I hope your daughter got a lot of tips. Bagging groceries is much harder than it looks. I should know: I was the worst bagger in the history of Winn-Dixie. I’m pretty sure that’s why they stuck me on the express lane. Next, I hope she kept good records. Without a 1099, it’s hard to figure the amount paid. When you’re paid in tips, I highly recommend keeping a tip journal (yes, this applies to wait staff and others who work for tips). Just jot down the amounts that you receive each week. If you keep excellent and contemporaneous records, the IRS will generally accept a tip journal as proof of compensation. With that, whether your daughter has to file her own return generally depends on two main things: whether she earned her money and how much money she made.

Earned income is income from wages, salary or self-employment; tips are considered earned income. If your daughter has earned income of less than $5,700 for the current tax year, she does not have to file a return or pay federal income tax so long as she is single and under the age of 65. Even if she doesn’t meet the criteria for filing, she should file a tax return if federal income tax was withheld from her income (which doesn’t sound like the case here) or if she qualifies for certain credits which would result in a refund. She’ll also need to file if she owes other taxes (check your state’s tax requirements for this one).

The rules are different for unearned income like dividends and interest. For children under the age of 18, or under the age of 23 and a full time student, the first $950 is considered tax-free and the next $950 is taxed at the child’s rate. Unearned income over $1,900 is taxed at the child’s parents’ tax rate (in other words, your tax rate). This is the so-called “kiddie tax.” It’s even more complicated if there is a mix of earned and unearned income. Check IRS Pub 929 for more details. Remember that these rules apply to children who are dependents. Those who are not dependents because of their age or filing status; or who are emancipated, like the ever adorable Drew Barrymore, have a different set of rules.

Allowances for Kids (when your kids invest their dollars like Buffett)                

Taxpayer asks:

Hi, My husband and I have decided to open a bank account for our son. We’re going to give him an allowance every week. He gets to keep part of it and put the rest in the bank. If he saves a certain amount, he gets a bonus allowance. The point is to teach him to save. My question for you is how do we report the money we’re giving him? And does he need to file taxes for the bank account? He is 8 years old and his allowance is $5 per week.

Taxgirl says:

What a great idea! I may have to try that one myself . . . There are no income tax consequences to your son for an allowance; similarly, there are no income tax consequences to you for giving an allowance. Technically, there could be gift tax consequences since an allowance is really a gift—but doing the math here, I’m guessing it’s rare that, together with your other gifts to your son, you hit gift tax type numbers ($13,000 per person per year for 2012). As to the bank account, interest reported to your son might be subject to income tax. However, the amounts that you’re talking about are small enough that they likely won’t be . . .

Assuming that you claim your son as a dependent and he has no earned income, he can earn up to $950 in unearned income (like interest and dividends) income tax free for federal purposes. There’s no need to report that income or file a return. The next $950 would be taxable at your son’s own tax rate. After that, using the “kiddie tax” rules, he would be taxed at your (meaning his parents’) marginal tax rate. It sounds like neither of these situations would apply to you but I wanted you to be aware of them. There are additional rules and exceptions which apply to the “kiddie tax” rules—I’m not going to discuss them here other than to say that the rules are much different if your child has earned income or significant unearned income. If that’s the case, you’ll want to consult with your tax professional. It’s also worth pointing out that these are the federal rules—your state may have different rules. Again, consult with your tax professional.

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