By setting special tax rules for your child's interest income, the federal government discourages you from using her bank accounts as a tax shelter. The rules known as the "kiddie tax" apply to interest on the account until she turns 19, or 24 if she's a full-time student. What rate she pays -- or whether her income is taxable at all -- depends on her circumstances.
The kiddie-tax rules say your child can receive up to $950 in unearned income without paying tax, as of 2012; for 2013, the limit is $1,000. Unearned income includes dividends and capital gains as well as interest. If your child earns, say, $500 in interest and $200 in dividends in 2013, there's no tax. Income above $1,000 is taxed at the rate that fits his total income. At $2,000, however, it's taxed at your own highest marginal rate.
When tax time rolls around, you have two options. Your child can file a 1040, along with a Form 8615 reporting her investment income. You can spare her -- or yourself -- the paperwork, by claiming her investment income as your own and paying tax on it. File an 8814 for each child whose income you assume. Crunch the numbers first, though -- you want to choose the path that gives the family the lowest tax burden.
The rules on kiddie tax don't apply unless you or some other adult claims your child as a dependent. If he's not a dependent, he files his own tax return and pays regular tax rates on investment income. Your child can't qualify as your dependent unless he lives with you half the year, though the IRS has many exceptions, such as hospital stays and living on a college campus. If he pays for more than half his own support, that disqualifies him too.
If you've set up a college savings account in your child's name, that interest is potentially taxable. The New York State Society of CPAs recommends a 529 or Coverdell account, which earns interest tax-free, rather than a regular bank account. Withdrawals from those accounts are also tax-free if you spend them on college. If your kid has enough earned income to set up an IRA, interest on that account is tax-free as well. With a traditional IRA, however, she will eventually pay tax on withdrawals.
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