If you have a minor child under age 14 who has investment income, such as interest, dividends, or capital gains on investments
that are in an account in the child’s name, you may be able to include that income on your income tax return, instead of filing a separate return for the child. But it may not necessarily be to your advantage to do so. You may avoid having to file another tax return, but you may end up paying more tax. And, if the child’s total investment income is over a threshold amount, the “kiddie tax” applies, and part of the child’s income will be taxed at the parent’s rate.
There are two rules that apply to the investment income of a minor child:
1. If the child’s total investment income is less than $8,000 (effective for tax year 2005), the income can be included on the parent’s return rather than filing a separate return for the child. The child’s income must be only from dividends, interest, capital gain distributions (such as from a mutual fund), and Alaska Permanent Fund dividends. If the child has capital gains or losses from the sale of stock, the parent cannot include the income and a separate return must be filed for the child’s income. If the child’s investment income is more than $8,000, a separate return has to be filed for the child, regardless of age. And, if any tax was withheld on the child’s income, or if estimated tax payments were made during the year on that income, a separate return would have to be filed for the child and the parents could not include the income on their return.
2. If the child’s investment income is more than $1,600, part of it may be subject to tax at the parent’s rate. The $1,600 is the threshold amount for having to pay tax at the parent’s rate, and is two times the amount allowed as a standard deduction for a dependent who has only investment income to report ($800 for 2005).
If the child’s only income is unearned income (investment income), and is $800 or less, the child is not required to file a return, and the parents cannot elect to include the income on their return. In effect, the child’s investment income up to $800 is not subject to tax because of the $800 standard deduction allowed.
If Parents Elect To Include Child’s Income
If the parents choose to include the child’s income on their return, rather than filing a separate return for the child, they need to complete Form 8814, Parents’ Election to Report Child’s Interest and Dividends, and file it with their Form 1040 or 1040NR. On Form 8814, the first $800 of the child’s income is not subject to tax, the next $800 is subject to a 10% tax, and any amount over $1,600 is taxed at the parent’s rate.
If the child has investment income of more than $1,600, the excess over this threshold amount is subject to tax at the parents’ top marginal rate. This is what is sometimes referred to as the “kiddie tax”. The intent is to prevent parents from lowering their tax on investment income by shifting income to a child in a lower tax bracket.
The kiddie tax applies if the child is under age 14 for the entire year. If the child reaches age 14 by the end of the year, this rule does not apply. For this purpose, if a child reaches age 14 on January 1st of the following year, he or she is considered 14 on December 31st of the tax year for which a return is being filed, and the rule would not apply.
There are two ways to report the income and pay the tax when the kiddie tax rule applies (when the child’s investment income is more than $1,600):
1. Include the child’s income on the parents’ tax return by filing Form 8814.
2. File a separate return for the child and include Form 8615 – Tax for Children Under Age 14 With Investment Income of More Than $1,600. This form can be filed with Form 1040A, 1040, or 1040NR. Form 1040EZ could not be used in this case.
If Form 8615 has to be filed, the parents have to prepare their tax return first, since their taxable income and income tax must be entered on Form 8615 for the child. If the parents are married filing separately, the numbers to be entered would be taken from the return for the parent with the higher income.
How the Tax Is Applied When Form 8615 is Filed with the Child’s Return
The first $1,600 of the child’s investment income is taxed at the applicable rate. The first $800 would not be subject to tax since the allowable $800 standard deduction would offset this amount of income. The next $800, up to the $1,600 threshold would be subject to tax at the normal rate (10% for 2005). The amount in excess of $1,600 would be subject to tax at the parents’ top marginal rate.
Effect on Parents’ Adjusted Gross Income and Tax
As indicated above, the child’s investment income in excess of $1,600 must be taxed at the parents’ top marginal rate.
If the child’s investment income includes qualified dividends or capital gain distributions, you may end up paying up to $40 more in taxes by electing to include the child’s income on your tax return. This is because if you make the election, the child’s income between $800 and $1,600 is taxed at 10%, rather than the 5% preferential rate that could apply to qualifying dividends and capital gain distributions if you filed a separate return for the child.
You should also determine the effect that including the child’s income on your return will have on tax deductions and credits that are based on your adjusted gross income (AGI). These include the amount you can deduct for contributions to your IRA; your itemized deductions for medical expenses, casualty and theft losses, and other miscellaneous deductions subject to the 2% of AGI limit; your credit for child and dependent care expenses; the child tax credit; and education credits and deductions. Also, if your AGI goes over the threshold for higher income taxpayers, your deduction for personal exemptions may be reduced.
Who Includes the Child’s Income?
Who includes the child’s income on their return depends on the parents’ marital status, how they file their returns, and if separate returns are filed, which parent has the higher income.
Parents Filing Jointly
If you, as the child’s parents, elect to include your child’s income and you are married filing jointly, all the child’s income is included on your joint return.
Parents Filing Separately
If you are married filing separately, all the child’s, or children’s income would have to be included on the separate return filed by the parent with the higher income.
Divorced or Separated Parents
For parents who are divorced or legally separated, the parent with custody for the greater part of the year would include the income.
If the custodial parent has remarried, the stepparent is treated as the child’s other parent for purposes of reporting investment income. The child’s income could not be included on the non-custodial parent’s return.
If the custodial parent and the stepparent file a joint return, the child’s investment would be included on their joint return. If they file separately, the income would be included on the return with the higher income – either the custodial parent’s return or the stepparent’s return.
Widow or Widow(er)
These same rules that apply for the custodial parent and stepparent would also apply in the case of a widow or widower who remarries.