- Unearned and earned income amounts determine a child's need to file a tax return.
- Investments in a child's name have limited tax benefits.
- Opening a Roth IRA for kids could be a tax-smart saving and investment strategy.
- For federal financial aid programs, 20% of a student's assets and 50% of income (over $6,420) are factored into aid calculations.
Maybe your child landed a first "real" job or a summer job at the local ice cream shop. Along with the exhilaration of a paycheck comes one of life's coming-of-age milestones—filing a tax return and paying taxes. It can be a valuable lesson.
In fact, if a child has income—whether it's from a job or from investments—there are tax implications. Understanding the taxation of a dependent child's income is essential for both the child and the parents. In addition to helping you and your child avoid owing more than necessary—or running afoul of the IRS—understanding and paying taxes is an important step in a child's journey to becoming a financially responsible adult.
Of course, complex tax situations should be discussed with a tax professional—but here are answers to 6 common questions that will help you and your child understand the primary tax-related issues related to dependent children's income.
1. Will my child need to file a tax return on income from a summer or after-school job?
If your child earned more than $6,350 in 2017, including tips, it's time to file a tax return. That figure may look familiar—it's the standard deduction for a single filer in 2017.
Read IRS publication 929 for more information.
In 2018, the standard deduction rises to $12,000 for individual filers. That means kids can earn up to $12,000 without paying federal income taxes in 2018.
Different rules might apply if your child has unearned income from savings and investments. We'll discuss that, plus self-employment income, in later questions.
Even if your child isn't required to file a return, there are good reasons to do so anyway. If the employer withheld federal income tax from the child's pay, they 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 their income won't exceed the $6,350 threshold in 2017, and no tax was owed in the previous year.
Another learning opportunity will come with your child's first paycheck if they are a W-2 employee. 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 paycheck is 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 as 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. Young workers might think that is great, because they 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 they would be required to file a tax return and pay a 15.3% self-employment tax when income exceeds just $400. This tax is for Social Security and Medicare. For payroll workers, the employer pays half of these taxes, but self-employed workers pay them all. Plus, being self-employed complicates the individual’s tax return because quarterly filings may be required.
A child is subject to the same tax rules as any other business owner. 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 be unavoidable. But look at it this way: Your kid is learning valuable lessons about the responsibilities of being an entrepreneur.
3. Will my child need to file a return for unearned income from investments?
The answer to this question depends on the type and amount of your child's income—and it can be confusing.
Only unearned income from investments
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 $1,050 for 2017.
Earned and unearned income
If your child has both earned income and unearned income, things get a bit more complicated. Your child will need to file their own 2017 return if either unearned income exceeds the $1,050 threshold or earned income exceeds the $6,350 threshold, or if the total of unearned and earned income is more than the larger of $1,050 or the child's earned income (up to $6,000) plus $350.
So, for example, if your child earns $5,600 from a summer job and has $300 in unearned investment income, they would not be required to file a return. That's because neither the $6,350 earned income, nor the $1,050 unearned income threshold was met and the total of earned and unearned income doesn't exceed $6,000 plus $350.
On the other hand, $600 in earned income and $600 in unearned income would trigger the filing requirement because the combined income of $1,200 exceeds the combined income threshold of $1,050. This can be confusing. Use the IRS Publication 929, Tax Rules for Children and Dependents worksheet to run the numbers.
4. Should I ever include my child’s income on my tax return?
You may be able to include a dependent child's income on your tax return if the income consists entirely of interest and dividends (as opposed to capital gains), if the amount of the unearned income is less than $10,000, and if the child is under age 19 or a full-time student under age 24. There's little to be gained from including a child's unearned income on your tax return—other than avoiding the hassle of preparing and filing an additional tax return for your child—which may be a compelling reason, many would argue.
In fact, your family could owe more in tax. For example, a child's unearned income between $1,050 and $2,100 would be taxed at 10% if it's included on your return. On the other hand, if you file a separate return for the child, the tax rate on that portion of the income may be as low as zero, because of the preferential tax rates for qualified dividends and capital gain distributions.
If you want more information about how this provision works, take a look at 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 this 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 2017, unearned income above $2,100 (from a taxable account) is taxed at the parents' highest marginal income 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 $1,050 of a child's unearned income is not taxed, and the next $1,050 is taxed at the child's marginal tax rate.
The tax rates on minors' unearned income were changed by the Tax Cuts and Jobs Act. Starting in 2018, unearned income above $2,100 is taxed at the rates that apply to trusts and estates.
Over the $2,100 threshold, unearned income:
- Up to $2,550 falls into the 10% bracket.
- Between $2,551 and $9,150 is in the 24% bracket.
- Between $9,151 and $12,500 is in the 35% bracket.
- Above $12,501 is in the 37% bracket.
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 the fundamentals of investing. But keep an eye on the child's account earnings. If they begin to exceed $2,100 a year, when progressively higher tax rates come into play, you might want to make some adjustments.
Another strategy is to open a Roth or Traditional IRA on your child's behalf. Up to $5,500 can be contributed for 2017 and 2018 each. But the amount deposited in the account cannot exceed the child's earnings for the year. Earnings grow free from federal taxes and in retirement, after age 59½, Roth IRA withdrawals are tax-free.
6. How do a child's income and investments figure into college financial aid?
This question is not specifically about paying taxes, 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.
Although the EFC formula is adjusted from year to year, in general it incorporates 20% of a student's assets (money, investments, business interests, and real estate); 50% of a student's income (after a $6,420 threshold); 2.6% to 5.6% of the parents' assets (not including the family house and retirement assets owned by parents or child); and 22% to 47% of a parent's income (based on a sliding scale).
As you can see, a child with significant investment resources and income could 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% versus 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 education expenses are free from federal income taxes and, in many cases, from state taxes.
For more information read Viewpoints on Fidelity.com: The ABC's of 529 savings plans.
For most students, the potential negative impact of part-time or summer employment on the college aid income formula isn’t going to 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.
Taxes can be complicated for kids too
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.
Next steps to consider
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