Landing a first job and learning the fundamentals of saving and investing are important coming-of-age lessons for children. But along with the exhilaration of a first paycheck comes one of life’s less joyous milestones—taxes.
Understanding the tax implications 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 six 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?|
The 2015 threshold for having to file a tax return is $6,300 of earned income, including tips. Different rules might apply if your child also 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 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 $6,300 threshold, and no tax was owed in the previous year. 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 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 attractive, 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 he or she 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
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 2015.
Earned and unearned income
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 2015 return either if unearned income exceeds the $1,050 threshold or if earned income exceeds the $6,300 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 $5,950 plus $350.
So, for example, if your child earns $5,600 from a summer job and has $300 in unearned income, he or she would not be required to file a return because neither the earned income nor unearned income threshold was met and the earned income doesn’t exceed $5,950 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.
|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. But other than avoiding the hassle of preparing and filing an additional tax return for your child, there’s little to be gained from doing so.
In fact, you could owe more in tax. For example, a child’s unearned income from $1,050 to $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 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 2015, unearned income above $2,100 (from a taxable account) 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 $1,050 of a child’s unearned income is not taxed, and the next $1,050 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 the fundamentals of investing. But keep an eye on the child's account earnings. If they begin to exceed $2,100 a year, when unearned income above that amount will be taxed at the parent's highest marginal tax rate, you might want to make some adjustments.
|6.||How do 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.
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 $6,300 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 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%, 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. For more information read Viewpoints: "The ABC's of 529 college 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.
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.
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