Parents want to provide for their children’s financial needs and setting aside money in an investment account is a great way to get kids off to a good start with their finances.  Parents establish custodial accounts in the name of the child with the parent as the custodian. The account is typically in the social security number of the child which can lead to a surprise at tax time!

In this case, a provision called the kiddie tax can apply to the investment income that the custodial accounts generate.  The general idea behind the kiddie tax is to prevent parents from using their children as tax shelters.

When does kiddie tax apply to a child? These are all the criteria that must be met:

  1. Child is under age 19 by the close of the tax year or is a full-time student under age 24
  2. Child has at least one living parent at the close of the tax year
  3. Child’s UNEARNED income of more than $2,200 (for 2019)
  4. Child does not file a joint tax return

For children over the age of 17, the kiddie tax applies only to those with earned income that doesn’t exceed one-half of their support.

Before enactment of the Tax Cuts and Jobs Act (TCJA) under the kiddie tax provisions, the net unearned income of a child was taxed at the parents’ tax rates if the parents’ tax rates were higher than the tax rates of the child.

The TCJA made changes so that, for tax years beginning after December 31, 2017, the taxable income of a child attributable to net unearned income was taxed according to the brackets applicable to trusts and estates.  Under the pre-TCJA law, taxable income of a child attributable to earned income was taxed under the rates for single individuals. These changes in the law led to higher taxes on the child’s unearned income.

New for 2019 the Act repeals the kiddie tax measures that were added by the TCJA.  As a result, the unearned income of children is taxed under the pre-TCJA rules and not at the trust/estate rates.

The effective date is for tax years beginning after December 31, 2019, however the taxpayers can elect to apply it retroactively to tax years which begin in 2018, 2019 or both.

To decide whether to make this election, taxpayers should compare the tax for 2018 under the TCJA rules with the tax under the pre-TCJA rules that were reinstated by the Act.  Then they can make a decision based on which set of rules provides the better result.  This will depend on the parents marginal rate and the amount and type of the child’s income.  Taxpayers who have already filed for 2018 and would benefit from the election should file an amended return.