Investment income earned by a child under 18 can be taxed in his or her parents' top tax bracket. There's a special form—Form 8615—for figuring the kiddie tax. It must be filed with the return of each of the half a million or so "kiddies" to whom the rules apply. Although children's returns once were among the easiest to complete, those that involve the kiddie tax are now among the most difficult. When developing the Form 8615, the IRS estimated that completing the single-page form would add nearly a full hour to the return-preparation chore.
You may be able to skip Form 8615 if:
Your child's entire income is from interest and dividends
Your child's total income is less than $8,500
Your child is under age 18 at the end of the year
If a child meets all the requirements listed above, the child's parents may simply report the child's unearned income on the parent's return by filling out Form 8814, avoiding the need for Form 8615 and the need for having a child escape file a tax return.
Form 8814 makes it clear that you do not simply add all the child's unearned income to your own taxable income. Not all of a child's unearned income is covered. On 2006 returns, only investment income over $1,700 can be taxed in the parents' bracket. The first $850 is tax-free, because up to $850 of a child's standard deduction can be used to shelter unearned income. The next $850 is taxed at the child's rate, probably 10% or 15%, unless long-term capital gains are involved, in which case a 5% rate might apply. Excess unearned income is nicked by the parents' rate, as high as 35% for interest.
There are reasons to be leery of this shortcut. For one thing, reporting a child's income on your return will increase your AGI, and that could cost you tax-saving deductions. Medical and miscellaneous expenses are deductible only to the extent they exceed a certain percentage of AGI. The higher your AGI, the more of those expenses can not be deducted. The right to deduct IRA contributions is also tied to AGI. The restrictions on itemized deductions and exemptions are triggered by rising AGI. The new child and college credits can also be lost as AGI rises. One more reason for not putting "kiddie income" on your return: doing so might result in a higher state tax bill for the family.
If your son or daughter has earnings from a job, that earned income is always taxed in the child's bracket. Salary, tips and self-employment income are examples of earned income. Almost all other kinds of income—including interest, dividends, capital gains, rents, and trust income—fall in the unearned income category and are vulnerable to the kiddie tax. The distinction between earned and unearned income depends on whether or not the income is compensation for work performed.
The kiddie tax disappears on the child's 18th birthday. If your child has his or her 18th birthday anytime during the year—even on New Year's Eve—the tougher taxing rules don't apply for any part of the year.