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A child who is considered a dependent on either or both of the parents’ tax return may still need to file a federal income-tax return depending on the type (earned or unearned) and amount of taxable income.
Fortunately, the new tax law treats a child’s unearned income (interest, dividends and capital gains) more favorably beginning with the 2018 tax year.
But don’t be misled: The tax on a child’s income is still a complex area that should not be taken lightly. Here’s what you need to know.
Who is a dependent child?
Children fall into three categories in the eyes of the Internal Revenue Code: under age 18 at the end of the year; 18 at the end of the year but didn’t have earned income equal to more than half of their support; or between 19 and 23 at the end of the year, didn’t have earned income that was more than half of their own support and were full-time students. Support includes items like lodging, food, utilities, clothing and medical costs.
A special rule applies to children born on Jan. 1: They are treated as if their birthday was on Dec. 31 of the prior year. For example, a child born on Jan. 1, 2000 turns age 18 on Jan. 1, 2018 but is treated under this tax provision as if they are 18 on Dec. 31, 2017.
How much income triggers a separate tax return?
It depends on the type of income.
• A child with only earned income (generally just wages and salary) must file if gross income exceeds the $12,000 standard deduction for a single taxpayer.
• A child with only unearned income (interest, dividends and capital gains) must file if gross income is more than $1,050.
• A child with both earned and unearned income must file if the total amount exceeds the larger of $1,050 or the earned income plus $350.
If a tax return isn’t required, the child’s income won’t be taxed. The parent can still claim the child as a dependent regardless of whether the income is taxed. Just remember that the new tax law eliminates the deduction for children, although that may be more than offset by the more generous child tax credit.
How is this simpler than the old rule?
The simplification is twofold. First, the child’s net unearned income is no longer added to the parent’s taxable income to determine the incremental tax liability, which was then allocated to the child’s tax return — and taxed at the parents’ marginal rate. A child’s net unearned income is generally defined as anything above $2,100 ($1,050 standard deduction for an individual who “may be claimed” as a dependent plus the $1,050 unearned income limit).
This separation from the parents’ taxes is even more beneficial where there is more than one child with net unearned income. Under the old rule, the total net unearned income of all the children was added to the parent’s taxable income and then prorated back to each of the children’s tax return, also at the parents’ tax rate.
Second, the tax on each child’s net unearned income is simply calculated using tax brackets applicable to trusts and estates. This is how interest and short-term capital gains of the child are taxed:
• $0 plus 10% on income over $0 but not over $2,550;
• $255 plus 24% on income over $2,550 but not over $9,150;
• $1,839 plus 35% on income over $9,150 but not over $12,500; and
• $3,011.50 plus 37% on income over $12,500.
The tax rates for the child’s long-term capital gains and qualified dividends are:
• 0% for capital-gains income up to $2,600;
• 15% for capital-gains income over $2,600 and up to $12,700; and
• 20% for capital-gains income over $12,700.
That means the child tax filer doesn’t benefit from the more favorable capital-gains tax rates that apply to single taxpayers. If the so-called kiddie tax wasn’t applicable, the 0% capital-gain rate would apply if total taxable income is less than $38,700 and the 20% capital-gain rate would apply if total taxable income is greater than $500,000.
Whether the new tax law’s approach for taxing the net unearned income of children produces a larger or smaller tax bill will depend on the family’s tax situation and the type of unearned income of the child. But at first glance, the new law should mean lower taxes for children with a modest amount of interest, dividend and capital gain unearned income.
If the child had a summer job or a part-time job, those earnings plus unearned income up to $2,100 less the child’s standard deduction ($12,000) would generally be treated as if the child was a single taxpayer. If the parents provided more than half of the child’s support, they could still claim any applicable child tax credits.
Finally, if a child has earned and/or unearned income, consider consulting a qualified tax adviser before making any decisions involving federal and state income taxes. Keep in mind that although the child is legally responsible for the tax liability, the parent can become liable under certain circumstances.
Anthony P. Curatola is the Joseph F. Ford Professor of Accounting at Drexel University’s LeBow College of Business and editor of the Taxes column for “Strategic Finance”.