Understanding What Is Unearned Income for a Child and How Kiddie Tax Rules Apply

It’s wonderful to see young people developing investment skills and financial literacy early in life. Building these habits during teenage years creates a strong foundation for long-term wealth management. However, income generated from investments is subject to specific tax rules—particularly a regulation known as the “kiddie tax.” Learning what is unearned income for a child, and how it gets taxed, is essential for any young investor and their parents aiming to make informed financial decisions.

Why Young Investors Need to Know About Unearned Income and Kiddie Tax

When a child receives income from sources other than work, the federal government applies special taxation rules. This happens because before 1986, wealthier families discovered a tax loophole: they could transfer investments to their children’s names and have all earnings taxed at the child’s lower income tax rate rather than the parent’s higher rate. Congress closed this gap through the Tax Reform Act of 1986, introducing the kiddie tax mechanism.

Today, understanding how this rule works helps families optimize their investment strategies and avoid unexpected tax bills. For young investors, grasping what is unearned income for a child—and how it differs from earned income—is the first step to tax-smart investing.

What Counts as Unearned Income for Your Child?

Your child’s income falls into two categories: earned and unearned. Earned income is straightforward—it’s money your child receives for work actually performed, such as wages from a part-time job or summer employment. Unearned income is everything else.

Specifically, a child’s unearned income typically includes:

• Interest from savings accounts or bonds
• Dividend payments from stocks or mutual funds
• Capital gains from selling investments (including capital gain distributions)
• Scholarship or fellowship grants not reported on Form W-2
• Unemployment compensation
• Taxable Social Security benefits and pension distributions
• Income received as a trust beneficiary
• Investment earnings from gifts or inherited property

An important nuance: if a child uses wages earned from working to open a savings account, the interest earned on those wages is still classified as unearned income. Similarly, investment income generated from property received as a gift—whether under the Uniform Transfers to Minors Act (UTMA) or other arrangements—is also considered unearned income.

Who Must Pay Kiddie Tax: Age and Income Requirements

Not every child with unearned income faces the kiddie tax. The rule applies only when all of these conditions are met:

Income Threshold: The child’s unearned income exceeds the annual limit. For the 2023 tax year, this threshold was $2,500 (increased from $2,300 in 2022).

Filing Requirement: The child must be required to file a tax return based on the total income.

Age Qualification: The child falls within specific age brackets:

• 17 years old or younger at the end of the tax year, OR
• Exactly 18 years old and earned income didn’t exceed half their support, OR
• A full-time student aged 19-23 whose earned income didn’t exceed half their support

Parental Status: At least one parent was alive at the end of the tax year.

Filing Status: The child doesn’t file a joint tax return.

Note: The kiddie tax applies to legally adopted children and stepchildren regardless of dependent status. Support includes all expenses for food, housing, clothing, education, medical and dental care, and similar necessities.

How Kiddie Tax Taxation Works: The Three-Tier System

When your child’s unearned income qualifies for kiddie tax treatment, that income is taxed in three distinct ways. Understanding this structure is crucial for calculating your actual tax liability.

Tier 1 - Tax-Free Amount: The first $1,250 of unearned income (as of 2023) escapes taxation entirely. This threshold matches the standard deduction amount for dependent children with no earned income.

Tier 2 - Child’s Tax Rate: The next $1,250 of unearned income is taxed at your child’s own marginal tax rate—typically much lower than the parents’ rate. This band represents the “cushion” below the kiddie tax threshold.

Tier 3 - Parents’ Tax Rate: Any unearned income exceeding $2,500 is taxed at the parents’ marginal rate. This is where the tax burden increases significantly.

To perform these calculations, parents must file Form 8615 (Kiddie Tax) with the child’s tax return. The form requires detailed income breakdown and parent income information. Notably, Form 8615 is attached to the child’s return only—not filed separately with the parents’ return.

A Real Example: How Kiddie Tax Impacts Actual Earnings

Consider Sloan, a 16-year-old claimed as a dependent on her parents’ joint return. During 2023, Sloan has:

• $100 from taxable interest in her savings account
• $5,400 in dividend income from an investment account her parents established
• $2,500 from capital gain distributions from an investment account her grandparents set up
• $7,000 in wages from part-time and summer employment

Sloan’s total unearned income is $8,000, and her earned income is $7,000. After applying her $7,400 standard deduction, her taxable income totals $7,600.

Here’s how her unearned income taxes are calculated:

• First $1,250 (tax-free): $0 owed
• Next $1,250 (at her 10% rate): $125 owed
• Remaining $5,500 (at her parents’ 24% rate): $1,320 owed

Total tax on unearned income: $1,445

If all $8,000 had been taxed at Sloan’s 10% rate (without kiddie tax), the bill would be only $800. The kiddie tax rule costs her an additional $645 in taxes—a significant difference.

Determining Which Parent’s Tax Return to Use

When both parents are married and file jointly, simply reference their joint return on Form 8615. However, special rules apply in other situations:

Married but Filing Separately: Use the return of the parent with greater taxable income. Exception: if the custodial parent qualifies as “unmarried” for head-of-household filing status purposes, use the custodial parent’s return.

Divorced or Legally Separated: Use the custodial parent’s return if unmarried. If the custodial parent remarried, the stepparent is considered the child’s “other parent,” and their combined return (if filed jointly) or the higher-income return (if separate) should be used.

Never-Married Parents: If they lived together all year, use the return of the parent with greater taxable income. If they didn’t live together for the full year, apply the divorced-parent rules.

Reporting Options: Parent’s Return vs. Child’s Return

Parents have an alternative approach if specific conditions are met. If a dependent child’s income consists solely of interest and/or dividends (including capital gain distributions), that income can be reported directly on the parent’s tax return rather than filing a separate return for the child. This option eliminates the kiddie tax entirely.

To elect this method, parents must file Form 8814 with their federal return. The child does not file their own return or complete Form 8615. This simplified approach works well for children with minimal investment income, though it may trigger other tax consequences depending on your overall tax situation. Review IRS guidance or consult a tax professional to determine if this option benefits your family.

Additional Considerations: Net Investment Income Tax

Children earning substantial unearned income may face an additional layer of taxation: the net investment income tax (NIIT). This 3.8% surtax applies when your modified adjusted gross income exceeds threshold amounts based on filing status:

• Single or Head of Household: $200,000
• Married Filing Separately: $125,000
• Married Filing Jointly or Surviving Spouse: $250,000

NIIT applies to net investment income including interest, dividends, capital gains, rental income, and royalties—though it excludes wages, unemployment benefits, and Social Security. To calculate NIIT, file Form 8960 with your return.

For many young investors, NIIT becomes relevant only at higher income levels, but it’s important to recognize that kiddie tax and NIIT can apply simultaneously, compounding tax obligations.

Smart Strategies: Using Tax-Advantaged Accounts to Minimize Impact

One of the most effective ways to protect a child’s investments from kiddie tax is to avoid traditional custodial accounts altogether. Instead, consider tax-advantaged accounts that grow without triggering this rule.

529 College Savings Plans allow funds to grow tax-free, with tax-free withdrawals when used for qualified education expenses. These plans don’t generate unearned income for kiddie tax purposes—the account itself is the owner, not the child.

Custodial IRAs operate similarly. While they can be set up as custodial accounts, they don’t trigger kiddie tax because funds grow tax-free and withdrawals (under specific conditions) are also tax-free.

Traditional Custodial Accounts (like UTMA accounts), by contrast, generate unearned income annually as dividends and interest accrue, making them subject to kiddie tax rules.

By strategically using 529 plans or IRAs for a child’s investments, families effectively sidestep the entire kiddie tax problem while still building substantial long-term wealth. The accounts grow without annual tax drag, and distributions are tax-free if requirements are met—a genuine win from a tax optimization perspective.

Key Takeaways for Young Investors and Parents

Understanding what is unearned income for a child and how kiddie tax rules function empowers families to make smarter financial decisions. The bottom line: unearned income above specific thresholds triggers taxation at the parents’ (higher) rate, potentially resulting in substantial additional taxes compared to standard child tax treatment.

By recognizing which income sources qualify as “unearned,” monitoring the $2,500 threshold, and exploring alternatives like 529 plans and IRAs, young investors and their parents can significantly reduce unnecessary tax liability while building lifelong investment discipline. For complex situations, consulting a tax professional ensures your family takes full advantage of available strategies while remaining fully compliant with current tax regulations.