Children under age 14 are subject to special tax rules, under an arrangement informally known as the “kiddie tax.” If you know how the kiddie tax works, you can save money while avoiding traps that often snare the unwary.
To begin with, the kiddie tax applies only to unearned income, which includes interest, dividends, and capital gains. In 2003, the first $750 worth of unearned income received by a child under 14 is untaxed while the next $750 is taxed at the child’s low rate. These $750 limits will increase gradually over the years, in sync with inflation.
The bottom line is that children under 14 can have only $1,500 in low-taxed investment income this year. Over the $1,500 mark, though, unearned income is taxed at the parent’s rate.
Typically, kiddies will owe only $75 in tax on $1,500 of unearned income: the second $750 will be taxed at the lowest federal rate, now 10 percent. Under the new tax law, though, dividends and long-term capital gains are now taxed at only 5 percent, for low-bracket taxpayers. Thus, a kiddie might pay only $37.50 in tax on $1,500 in unearned income, if the taxable income consists of dividends and long-term gains.