Could the Kiddie Tax Create an Unexpected Tax Bill for Your Family?

Parents and grandparents often look for ways to help younger family members achieve important financial goals, whether it’s paying for college, purchasing a first home, or building long-term wealth. Gifting investments or other assets is one strategy families may consider as part of broader financial and estate planning. However, many families are surprised to learn that these gifts can sometimes create unexpected tax consequences.

One commonly overlooked rule is the “kiddie tax.” Designed to prevent families from shifting investment income to children in lower tax brackets, the kiddie tax can result in certain unearned income being taxed at the parents’ higher tax rate rather than the child’s rate.

Understanding when these rules apply can help families make more informed gifting decisions and avoid unexpected tax bills.

What Is the Kiddie Tax?

The kiddie tax generally applies to certain children and young adults who receive unearned income above annual IRS thresholds. Unearned income includes investment-related earnings rather than compensation from employment.

Depending on the child’s age, student status, and financial support, a portion of this income may be taxed using the parents’ federal income tax rate instead of the child’s own rate.

While many families assume a child with little or no earned income will pay little tax on investment gains, that is not always the case.

Income That May Be Subject to the Kiddie Tax

The kiddie tax can apply to many different forms of investment income, including:

• Interest income
• Dividend income
• Capital gains from the sale of appreciated securities
• Certain trust and estate distributions
• Royalty income
• Rental income
• Taxable scholarship income in certain situations
• Distributions from inherited retirement accounts

By contrast, earned income such as wages from a job generally are not subject to the kiddie tax.

Who May Be Affected?

The rules typically apply to children under age 18, as well as many full-time students under age 24 who do not provide more than half of their own financial support through earned income.

As a result, college students who file their own tax returns may still be subject to the kiddie tax even after reaching adulthood. Families are often surprised to discover that a child who appears to be in a very low tax bracket, may still owe tax based on the parents’ income.

Although there are several exceptions, determining whether the kiddie tax applies, often requires reviewing both the child’s financial situation and the parents’ tax circumstances.

Common Planning Situations

The kiddie tax most commonly arises when appreciated investments or income-producing assets are transferred to younger family members.

For example, grandparents may gift appreciated stock to help pay for a grandchild’s college education, expecting the child to recognize the gain at a lower tax rate. If the kiddie tax applies, however, some or all of the gain, could instead be taxed at the parents’ higher rate.

Similarly, transferring dividend-paying securities or other income-generating investments may create larger tax liabilities than expected if the child remains subject to the kiddie tax rules.

This does not mean gifting investment assets is a poor strategy. Rather, it highlights the importance of understanding the tax implications before making significant transfers.

Planning Considerations

Families considering gifts of investment assets should evaluate several factors before completing a transfer, including:

• The recipient’s age and student status
• The amount of anticipated investment income or capital gains
• Whether appreciated assets are transferred before or after a sale
• The potential tax implications of different gifting approaches
• How the transfer fits within broader estate, education, and financial planning objectives

Coordinating these decisions with broader estate, education, and investment planning objectives can help minimize unexpected tax consequences.

How LMC Can Help

Gifting strategies continue to play an important role in estate planning and wealth transfers, but understanding the potential tax implications is essential before making significant gifts. At LMC, we help individuals and families evaluate gifting strategies, assess the tax consequences of transferring investment assets, and develop tax-efficient plans aligned with long-term financial objectives. If you have questions about the kiddie tax or family gifting strategies, contact your LMC advisor to discuss your specific situation.