Smart Ways to Minimize Kiddie Tax on Your Scholarships

Smart Ways to Minimize Kiddie Tax on Your Scholarships

As a parent or guardian, sending your child to school can be a challenging and costly endeavor. However, scholarships can make the process less burdensome and financially intensive. Unfortunately, the IRS may place a tax on scholarship earnings called the “Kiddie Tax”, which can put a damper on the benefits. This tax is particularly relevant when the scholarship holder is a dependent teenager, student, or has significant earnings from passive investments. In this article, we will walk you through the smart ways to minimize Kiddie Tax on your scholarships.

Understanding the Kiddie Tax

The Kiddie Tax was introduced to discourage parents from placing assets in their child’s name, to minimize taxes. The tax is designed to apply to the unearned income by dependent children under the age of 18 or those who are between the ages of 18 and 24 but still full-time students. These rules also apply to children who have been financially dependent on their parents for more than half of the year, regardless of their age. Kiddie Tax rates are associated with trust and estate tax rates, currently at 37% for a portion of taxable income.

Reducing Kiddie Tax on Your Scholarships

Now that you know about the Kiddie Tax, let’s dive into some ways to reduce them:

1. Encourage Your Child to Maximize Scholarships

Reducing unearned income, such as investment earnings, rental income, and savings account interest is one of the possible steps to minimize kiddie taxes. Encouraging your child to maximize student aid resources and scholarships is an excellent way to achieve this goal. If more of the scholarship goes towards qualified education expenses (QEE), the less taxable income your child will have and the lower the Kiddie Tax.

2. Split Scholarships between Different Years

If your child is eligible to receive more than one scholarship, consider splitting the funding into different years. This strategy can help to reduce the income on which tax will be applied. By splitting the income in different years, you reduce the probability of putting your child in a higher tax bracket, which can result in higher taxes.

3. Invest in Tax-Deferred Accounts

Investments that generate qualified dividends and long-term capital gains can trigger the Kiddie Tax. One solution to this problem is to hold your investments in tax-deferred accounts, such as 401(k)s or IRAs. Investing money in these tax-advantaged accounts can lower your tax bill while reducing unearned income from investments and thus Kiddie Taxes.

4. Use 529 College Savings Plans

Additionally, you can invest in a 529 college savings plan to save for qualified education expenses (QEE) for your child. While contributions to a 529 account are not deductible, the account grows tax-free. When the account funds are withdrawn to pay for qualified expenses, there is no federal tax liability. Additionally, many states offer tax benefits for contributing to these accounts, making them a smart way to minimize Kiddie Taxes.

Conclusion

In conclusion, scholarships are a great way to reduce college costs for your child. However, if your child is earning significant amounts of money from scholarships or investments, you may need to pay attention to Kiddie Taxes. By reducing unearned income, splitting income over multiple years, investing in tax-deferred accounts, and using 529 college savings plans, you can effectively minimize the Kiddie Tax. Through these smart ways, you can get the most out of your scholarships and ensure you’re maximizing the financial benefits they offer.