From saving for college to landing a first job, a child’s journey through life often involves taxes—for parents as well as the young taxpayer.
“Kids are expensive,“ says Mark Luscombe, principal federal tax analyst for accounting research and software provider, Wolters Kluwer, CCH. “But knowing when a child must file a tax return and ways to potentially reduce taxes on kids’ investment accounts might save some money along the way.”
Of course, complex tax situations should be discussed with a tax professional, but here are answers to six common questions that will help you and your child understand the primary child-related tax issues.
1. Will my child need to file a tax return on income from a summer job?
The 2014 threshold for having to file a tax return is $6,200 of earned income, including tips. Different rules might apply if your child also has unearned income from savings and investments, and we’ll get to that situation later.
But even if your child isn’t required to file a return, there are good reasons to do it anyway. If the employer withheld federal income tax from the teenager’s pay, he or she will have to file a return to receive a refund—if one is due. Your child might be able to avoid withholding by claiming an exemption on Form W-4, provided the child is certain his or her income won’t exceed the threshold and no tax was owed in the previous year. Still, filing a tax return can be a good experience for your child, and the IRS might not look kindly on someone who files for an exemption and then ends up exceeding the threshold.
Another learning opportunity will come with your child’s first paycheck. In addition to federal—and possibly state and local—tax withholding, the pay stub will reflect withholding for Social Security, Medicare, and possibly unemployment taxes. Although it may come as a surprise to kids when they see that their first check is for less than they actually earned, it can be the start of valuable lessons in financial planning.
2. What if my child is paid as a contractor, not a payroll employee?
Some employers may want to avoid the trouble of tax withholding and other responsibilities by classifying a worker as an independent contractor for tax purposes. A young worker might think that sounds attractive, because he or she won’t have income and payroll taxes withheld from each paycheck.
However, the downside of such an arrangement can be significant. For tax purposes, your child would be treated as self-employed, meaning that he or she would be required to file a tax return and pay a 15.3% self-employment tax when income exceeds just $400. The tax is for Social Security and Medicare. For payroll workers, the employer pays half of these taxes. Plus, being self-employed complicates the individual’s tax return because quarterly filings may be required.
If your child earns more than $400 through babysitting, mowing lawns, or any of a wide range of similar money-making endeavors, the self-employment tax might not be avoidable. A child is subject to the same tax rules as any other business owner. But look at it this way: Your kid is learning valuable lessons about the responsibilities of being an entrepreneur.
3. What if my child has unearned income from investments?
The answer to this question depends on the type and amount of your child’s income. If the child has only unearned income—capital gains or dividends and interest from investments—the threshold for having to file a tax return is $1,000.
But if your child has both earned income and unearned income, things get a bit more complicated. He or she will have to file a separate return if either the $1,000 threshold for unearned income or the $6,200 threshold for earned income is met. Filing a tax return also will be required if the combined income exceeds $1,000 or the child’s earned income (up to $5,850 in 2014) plus $350, whichever is larger.
So, for example, if your child earns $5,500 from a summer job and has $300 in unearned income, he or she would not be required to file a return. On the other hand, $600 in unearned income and $500 in earned income would trigger the filing requirement.
4. Should I ever include my child’s income on my tax return?
If your dependent child’s income consists entirely of interest and dividends (as opposed to capital gains), you generally can include that income on your tax return. However, aside from avoiding the hassle of preparing and filing an additional tax return for your child, there’s little to be gained from doing so.
By filing a separate return for your child, the income is taxed at the child’s rate, which is probably lower than yours. Plus, adding the income to your return could push you into a higher marginal tax bracket, making the option even less appealing.
A parent of a child under age 19 (or under age 24 if a full-time student) may be able to elect to include the child’s interest and dividend income on the parent’s return, but only if the child has interest and dividends, and no earned income. If the parent makes this election, the child does not have to file a return. See Parent’s Election To Report Child’s Interest and Dividends in Part 2 of IRS Publication 929.
5. Is there any tax advantage to having investments in my child’s name?
Keeping a significant amount of investment assets in a child’s name used to be a popular tax strategy, because it allowed investment income to be taxed at the child’s presumably lower rate. The so-called “kiddie tax” enacted in 1986 was aimed at preventing parents from abusing the strategy, and in 2006 the rules became even more restrictive.
For dependent children age 18 and younger (or under age 24 if a full-time student) in 2014, unearned income above $2,000 is taxed at the parents’ highest marginal tax rate, which is likely to be higher than the capital gains rate that would otherwise apply if the investments were in the parents’ names. Below that threshold, the first $1,000 of a child’s unearned income is not taxed, and the next $1,000 is taxed at the child’s marginal tax rate.
Although there’s little tax advantage to having investments in a child’s name, it still might have some educational value. Opening an investment account for a child—and periodically contributing to it—can be a good way to engage the child in learning the fundamentals of investing. But keep an eye on the account’s earnings. If they begin to exceed $2,000 a year, you might want to make some adjustments.
6. How does a child’s income and investments figure into college financial aid?
This isn’t a tax issue, but it is a frequently asked follow up to the question of whether investment accounts should be put in a child’s name. A good starting point for finding the answer is the federal formula for calculating the expected family contribution (EFC) toward a higher education. Get an estimate with the College Board EFC calculator.
The current EFC formula, according to Finaid.org, incorporates 20% of a student’s assets (money, investments, business interests, and real estate); 50% of a student’s income (after a $6,200 threshold); 0% to 5.6% of the parents’ assets (not including the family house and retirement assets); and 0% to 47% of a parent’s income (based on a sliding scale).
As you can see, a child with significant investment resources and income can be adversely affected in the financial aid calculation. But keep in mind that there’s not much tax incentive to put a large amount of investments in a child’s name anyway, and one of the best ways to save for college today is a 529 plan that names the future student as the beneficiary, not the owner. These assets are considered parental assets and are factored into federal financial aid formulas at a maximum rate of about 5.6%, vs. the 20% rate that is assessed on student assets. A child-owned 529 account (in a custodial account) is also treated as an asset of the parent for Free Application for Federal Student Aid (FAFSA) purposes.
A 529 plan can have significant tax benefits for the owner, in that any earnings grow federal income tax deferred and withdrawals used for qualified higher education expenses are free from federal income taxes and, in many cases, from state taxes.
Regarding the income portion of the formula, most students aren’t going to earn enough from part-time or summer employment to make the potential negative impact on college aid outweigh the many financial and life lessons learned by having a job.
In addition, college financial aid experts point out that the formula for calculating aid eligibility is subject to change, that many colleges have their own formulas, and that financial aid officers have great latitude in deciding how much aid a child receives and in what form.
So long as your child remains a dependent, there will be tax implications for you. With a little smart tax planning—and consulting a tax professional if your situation is complex—you may be able to manage the impact. And by involving your children in tax decisions and preparing tax returns when they reach the appropriate age, you can teach them about this important aspect of lifelong financial planning.