On December 20, 2019, President Trump signed into law the Appropriations Act of 2020, which included a number of tax law changes, including retroactively extending certain tax provisions that expired after 2017 or were about to expire, a number of retirement and IRA plan modifications, and other changes that will, as a whole, impact a large portion of U.S. taxpayers. This article is one of a series of articles dealing with those changes and how they may affect you.
Your dependent child who worked during the year or had investment income, such as interest or dividends, may be required to file a tax return, depending upon the type and amount of the income. Years ago, to prevent parents from putting their investments in their children’s names to avoid or significantly reduce the tax on their investment income, Congress passed what is commonly referred to as the kiddie tax. The kiddie tax taxes children’s income in excess of a small allowance at the parent’s top tax rate.
More recently, as part of the 2017 tax reform, Congress modified the kiddie tax structure, so that the children’s investment income in excess of the small allowance ($2,200 for 2019) is taxed at the fiduciary tax rates*, which can very quickly reach the maximum tax rate. On the other hand, the tax reform virtually doubled the standard deduction (it is $12,200 for 2019 for someone using the single filing status), providing children with substantial tax-free income from working.
That change to how the kiddie tax is figured created an unintentional tax increase for survivors of service members and first responders who died in the line of duty. As a result, Congress has decided to scrap the new method, which used fiduciary rates, and to revert to the original kiddie tax computation, beginning in 2020, resulting in the child’s net unearned income being taxed at the parents’ tax rate, if it’s higher than the child’s tax rate.
Amended Return Possibility – Taxpayers can choose whichever method provides the lowest tax for 2018 and 2019 and can amend the 2018 return if it provides a better outcome. This will especially benefit taxpayers with substantial unearned income.
Unearned income generally includes investment income such as taxable interest, dividends (including capital gain distributions), and capital gains, as well as rents, royalties, pension income, survivor benefits, the taxable part of Social Security benefits, taxable scholarship and fellowship grants not reported on Form W-2, and other income types.
A dependent child is defined as being either under the age of 19 during the tax year or under 24 if he/she is a full-time student. Also, to be a dependent, the child needs to live with you for more than half of the year (unless he/she is away due to a temporary absence that includes living away from home while attending school), and although there are no support requirements, the child cannot be self-supporting. When considering whether the child is self-supporting, don’t confuse support for the child with the child’s income. Income that is saved is not used for support.
How a Child’s Income Is Taxed
- Wages – When children only have earned income (wages), they file their own tax return and can claim the standard deduction. Thus, only their earnings in excess of the standard deduction, which is $12,200 for 2019, is subject to income tax. As a result, if their earnings are less than the standard deduction, they need not file a tax return unless it would need to be filed for them to claim a refund of withheld income taxes.
- Self–Employed Income – If your child is an entrepreneur and has net income from self-employment, then in addition to income tax, he/she may owe self-employment tax. Self-employment tax is only assessed if the net self-employment income is above $433. Thus, if your child’s self-employment net income is more than $433, he/she must file a return, even if the total income is less than the standard deduction.
- Investment Income – If your children only have investment income, such as interest and dividends, their standard deduction for 2019 will be $1,100, but for the kiddie tax computation, any investment income in excess of $2,200 (the special allowance previously mentioned in this article) will be taxed, either at fiduciary rates – which start at 10% and reach 37% when the investment income in excess of the special allowance reaches $12,750 (the TCJA method) – or at their parents’ marginal tax rate (the pre-TCJA method that Congress brought back).
- Earned Income and Investment Income – This is the most complicated because the standard deduction is the greater of $1,100 or the child’s earned income plus $350, but it should not exceed the $12,200 standard deduction for a single individual, while the special allowance for the kiddie tax is $2,200. Generally, in this situation and using the TCJA method, investment income over $350 will be taxed at fiduciary rates, and earned income over the remaining standard deduction will be taxed at the regular single tax rates. Otherwise, if the TCJA method isn’t used, the child’s tax will be the greater of the tax on all of the child’s income or the sum of the tax on the child’s earned income plus the child’s share of the allocable parent tax. The TCJA method is only available for 2018 and 2019.
Parents’ Election – Parents may elect to include their child’s interest and dividend income (including capital gain distributions) on their own tax return if the total is less than $11,000, instead of the child filing a return of his/her own. However, this election cannot be made if the child has other types of income, either earned or unearned. In addition, filing in this manner may result in a larger tax liability.
Who Should Be Responsible for Filing the Child’s Return? Whether your children’s income is earned or unearned, they may be too young to prepare their own tax return. Then, the responsibility to do so is yours. If your children have the maturity and ability to file their own return, you may want to provide them with this important lesson of being a taxpayer. However, if you make them responsible for filing their own return, make sure they check the “dependent of another” box, or else the IRS will deny you the dependency for the child and create a mess that will be difficult to straighten out.
Retirement Savings Opportunity – If your children have earned income, they can set aside money in an IRA for their eventual retirement, although they may be reluctant to give up any of their hard-earned money from their summer job or regular employment. A child or young adult is probably not at a stage in life to begin thinking about retirement. However, if you, a grandparent, or others have the financial resources to do so, the amount of an IRA contribution could be gifted to the children, giving them a great start toward their retirement savings and hopefully a continuing incentive to save for their retirement. The maximum amount they can contribute for 2019 is the lesser of their earned income or $6,000.
Roth IRAs are actually a better alternative; unlike traditional IRAs, Roths provide tax-free income at retirement. However, the contribution to a Roth is not deductible; thus, income over $12,200 would not be tax free. Even so, the tax rate at the lower income level is only 10%, and it may be worth paying a small tax now to gain the tax-free retirement income provided by a Roth IRA. An IRA contribution for 2019 can be made up to April 15, 2020.
Signing the Return – Parents who prepare their children’s return can either have them sign for themselves or do so on their behalf, thus signing for them as their guardian or parent. This is a good idea in either case, as this notation provides with you the ability to speak on your child’s behalf if the IRS audits or questions the return.
A child’s return can be tricky to prepare. Please call this office for your child’s tax-preparation needs.
*Fiduciary tax rates are the income tax rates for trusts and estates.
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