The new retirement planning law passed by Congress late last year—the Setting Every Community Up for Retirement Enhancement (SECURE) Act—includes a tax provision that has nothing to do with your golden years. Accordingly, the way the “kiddie tax” is calculated reverts to the method used before the Tax Cuts and Jobs Act (TCJA) of 2017 was enacted.
Although the kiddie tax provision in the SECURE Act is effective for 2020 and thereafter, you can elect to have it apply for either the 2018 or 2019 tax years—or both.
Background: Generally, income is taxed at the tax rate of the individual who receives it. Therefore, if you are in the top 37% tax bracket (reduced from 39.6% by the TCJA), any additional dollars you earn are taxed at the rate of 37%. On the other hand, if your child is the 10% bracket, the child pays tax at a maximum rate of only 10%.
However, a special rule applies to certain children who receive unearned income—like dividends and capital gains from investments— above an annual threshold. If a dependent child is under age 19 or a full-time student under age 24, the excess unearned income is subject to the kiddie tax. The annual threshold is adjusted for inflation, but recent increases have been relatively small or nonexistent. For 2019 returns, the threshold is $2,200. It remains the same in 2020.
Prior to the TCJA, the kiddie tax was based on the top tax rate of the child’s parents, regardless of the source of the income. For example, if a dependent child had $1,000 in unearned income above the annual threshold and the parents were in the 25% tax bracket, the resulting kiddie tax was $250. However, under the TCJA, the tax calculation was based on the tax rates in effect for estates and trusts. This change went into effect in 2018.
Potential problem: The TCJA change produced a bigger kiddie tax liability for certain families than the previous method did. Reason: As opposed to the tax brackets for individuals, the brackets for estates and trusts are extremely compressed. As a result, the higher tax rates may kick in sooner, causing an increased tax liability.
Now the law has been changed to go back to the way it was before the TCJA. The SECURE Act again requires the kiddie tax to be based on the top tax rate of the child’s parents.
Note that you can choose to have this change apply on your 2019 return. Furthermore, if it suits your needs, you can file an amended return for 2018 to rely on the pre-TCJA kiddie tax computation.
Going forward, keep an eye on your child’s unearned income. When possible, try to keep it below or near the annual kiddie tax threshold.
Reminder: Every situation is different. Consult with your professional tax advisor concerning the application of the kiddie tax rules.
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