The Tax Cuts and Jobs Act of 2017 (TCJA) has effectively simplified the so-called “kiddie tax,” according to an expert in the Center for Public Finance at Rice University’s Baker Institute for Public Policy.
Joyce Beebe, a fellow in public finance, outlined her insights in a new report, “Taxing Teens: Working Children, Family Businesses, and the Kiddie Tax.” The report reviews different types of income sources for children and young adults and the associated tax implications. It also discusses the revised kiddie tax rules.
The most common way a child can earn money is through formal and informal jobs, Beebe said. An Organisation for Economic Co-operation and Development study indicates that about 55 percent of U.S. high school students surveyed received work-related income and about the same percentage held a bank account.
The TCJA increased the standard deduction for single filers from $6,350 in 2017 to $12,000 in 2018, which means that children who earn more than $12,000 in labor income in 2018, or approximately $1,000 per month, will need to file a federal income tax return. “The filing process may not be as daunting as parents’ filing requirements because the child may be able to use the simpler Form 1040-EZ” if certain criteria are met, according to Beebe’s report.
“Two conditions that would disqualify a child from using Form 1040-EZ would be if he claims an individual retirement account (IRA) deduction or has a large amount of non-labor income, for example,” she wrote. “If a child has federal income tax withheld by his employer but his income is under the reporting threshold, or the tax withheld exceeds his actual tax liability, he would need to file a return to get a refund. Under the TCJA, the two lowest income brackets have not changed much, but the tax rate is lower for the second-lowest income bracket (12 percent versus 15 percent).
“For a child with high labor income, her gross labor income after considering the standard deduction would need to exceed $50,700 in order for the 22 percent tax rate to apply to a portion of her income, or nearly $100,000 to move to the 24 percent rate. Given that the median annualized income for U.S. workers ages 16 to 24 in 2018 is $26,988, a child would have to earn two to four times the median child income before she is subject to the 22 percent and 24 percent tax rate thresholds.”
Beebe said the TCJA also simplifies the kiddie tax by effectively applying ordinary and capital gains rates applicable to trusts and estates to a child’s net unearned income. “A child’s tax is therefore unaffected by his parents’ tax situation or his siblings’ unearned income,” she wrote. “Most observers believe the new provision is going to simplify kiddie tax compliance because it no longer requires families to combine the unearned income of siblings or half-siblings, and parents’ marginal tax rates and marital status will not affect the kiddie tax calculation. However, some cautioned that the new rule is still very complicated, as the tax code appears to require each child subject to the kiddie tax to construct his own rate table using his earned taxable income and other relevant items.”
Before the TCJA, children may have been subject to their parents’ long-term capital gains and qualified dividends rates of 15 percent or 20 percent; after the TCJA, they will pay the trust rate of 15 percent or 20 percent, but the income brackets are much more compressed, Beebe said.
“As a result, the lock-in effect after the TCJA is likely to be equally prominent, if not more so,” she wrote. “Some wealth advisers also pointed out that, depending on donors’ objectives, the traditional ‘leave an IRA to grandchildren’ planning mechanism may no longer be tax-advantageous under the new kiddie tax rules. The main advantage of this planning strategy has been that the inherited IRA essentially extended distribution horizons over the beneficiaries’ lifespan, providing decades of asset growth and tax deferral. Many grandparents employ this strategy to help their grandkids pay for college tuition, but the new kiddie tax may impose a large capital gains bill by taxing the realized capital gains at the trust rate. If grandparents would still like to follow this strategy, a Roth IRA would be a better vehicle.”
Beebe concluded, “A large portion of U.S. teens receive work-related income, and many also have non-labor income from either savings, investments or family asset transfers. They use these resources to finance current consumption, college tuition, retirement savings and tax payments, among other spending and savings decisions. Teaching kids about managing money is more an art than a science. However, preparing children to follow tax and other regulatory rules requires diligence to thoroughly follow all the requirements, patience in calmly researching the tax code and an open mind to adapt to occasional changes in the rules and regulations.