Great, Susan has a good summer job and works after school to help save money for her education. In addition, her parents want to help her out by investing money in her name. Along with these paychecks come one of life’s two “guarantees” TAXES! (death and taxes). Depending on the income she received she could be in for a rude awakening!
The 2018 IRS tax rules are substantially different than prior years regarding kids and taxes. First let’s differentiate “earned income” from “unearned income”. Earned income is from a job, whether it is on a paycheck from a company or cash paid for services rendered. Unearned income is primarily from investments and includes interest and dividends. Other forms include alimony, pensions and social security.
Each of these income types has different rules, even when combined.
1. Susan is a 17 year old dependent child and lives with her parents. She worked over the summer and part time during the school year, in 2018 she will make $13,000 in wages/tips. She does not have any unearned income. Does she have to file and pay federal income tax for 2018?
YES. She must file a tax return because she has earned income only and her total income is more than the standard deduction amount for 2018 of $12,000. If Susan had made $11,999 she would not be required to file or pay any federal taxes.
Starting in 2018, the standard deduction for a dependent child is total earned income plus $350, up to a maximum of $12,000. Thus, a child can earn up to $12,000 without paying income tax. This is a substantial increase over 2017.
Even if your child isn’t required to file a return, there are good reasons to do so anyway. If they had federal income tax withheld from their paycheck, they should file a return to receive a refund of the withholding’s.
2. Susan was paid as a “contractor”, not as a payroll employee?
Some employers may want to avoid the hassle of tax withholding and other costs by calling a worker an “independent contractor” for tax purposes, or just write them a check every 2 weeks. Susan might think that is just great, because she won’t have income and payroll taxes withheld from each paycheck. At the end of the year they just send that dreaded 1099-Misc (box 7) form to Susan.
This unfortunately is going to costs Susan some money out of pocket. For tax purposes, Susan would be treated as self-employed, meaning that 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 type workers, the employer pays half of these taxes, but self-employed workers pay them all. Yes, they can deduct ½ of this amount as a deduction to income, but this is not as good a deal as they get from a true employer paying ½.
Susan is now subject to the same tax rules as any other business. If your child earns more than $400 through babysitting, dog walking, lemonade stands, or any of a wide range of similar money-making endeavors, the self-employment tax might be unavoidable. But look at it this way, Susan is learning valuable lessons about the responsibilities of being an “entrepreneur”.
3. Would Susan need to file a return for unearned income from investments in her name?
If Susan has only unearned income like capital gains or dividends and interest from investments, the threshold for having to file a tax return is $1,050.
4. Susan is a 19 year old college student claimed as a dependent on her parents returns, received $250 taxable interest income (unearned income) and earned $2,500 from a part-time job during 2018 (earned income).
She does not have to file a tax return. Both her unearned and unearned income are below the thresholds, and her total income of $2,750 is less than her total earned income plus $350 ($2,850). The rule is, earned and unearned income together total more than the larger of (1) $1,050, or (2) total earned income (up to $12,000) plus $350.
However, there are different rules if your child has unearned income from savings and investments, plus self-employment income.
There are reasons a parent might want to put a child’s income on their return, you can read more about this, just 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 benefit of having investments in my kid(s) name?
Keeping a lot of investments in a kids account used to be a popular tax strategy, because it allowed investment income to be taxed at the child’s lower rate. The so-called “kiddie tax” in 1986 was aimed at preventing parents from abusing this strategy, and in 2006 the rules became even more restrictive.
For dependent kids age 18 and younger (or under age 24 if they are 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 minor’s unearned income were changed by the new 2018 tax law. Starting in 2018, unearned income above $2,100 is taxed at the rates that apply to trusts and estates.
So there is little tax benefit to put these investments in your kid’s name.
Caveat: All complicated tax situations should be discussed with your tax professional.