The Kiddie Tax Trap That Could Cost Your Family Thousands in College Funding

Many high-income families assume that shifting income to their children is a simple and smart move to reduce taxes and fund college more efficiently. But if you’re not careful, this strategy can backfire thanks to a little-known IRS rule called the kiddie tax. It’s one of the most overlooked tax traps in college planning, and it’s quietly draining thousands of dollars from families who think they’re doing the right thing.

What Is the Kiddie Tax?

The kiddie tax is a federal tax rule that applies to unearned income, such as interest, dividends, and capital gains, received by children under the age of 24. Once that unearned income exceeds a set threshold ($2,700 for 2025), the excess is taxed at the parents’ marginal tax rate instead of the child’s lower rate.

The rule was initially created to prevent wealthy families from avoiding taxes by moving investment income into their children’s names. However, in the context of college funding, it creates significant problems for families attempting to be proactive with income planning.

Why the Kiddie Tax Matters for College Planning

If your plan involves transferring appreciated assets to your child and having them sell or use those funds for tuition, you may inadvertently trigger the kiddie tax without realizing it. Many parents assume that giving stock, mutual funds, or savings bonds to their student is a tax-smart move. But once the income from those assets crosses the annual threshold, the IRS steps in and applies your tax rate, not theirs.

The result? A much smaller pool of funds is available for college. What you thought would be taxed at 0% or 10% could instead be taxed at 24% or higher, depending on your income.

When the Kiddie Tax Applies

The kiddie tax kicks in when:

• Your child is under the age of 18, or
• Your child is age 18 but doesn’t earn enough to support themselves, or
• Your child is a full-time student between the ages of 19 and 23 and is still considered your dependent

If your child meets any of these criteria and receives more than $2,700 in unearned income, the excess gets taxed at your rate. And that includes capital gains from assets you transferred to them.

Common Mistakes That Trigger the Kiddie Tax

One common error is funding an investment account in the child’s name with the intention of using the earnings for tuition. While this may seem like a good way to lower your tax burden, any unearned income over the threshold becomes subject to the higher rate.

Another mistake is gifting appreciated assets, such as stock that has grown in value, and having the student sell them to generate college funds. Unless the timing and structure are carefully planned, this can instantly trigger the kiddie tax and eliminate much of the intended benefit.

How to Avoid the Kiddie Tax Trap

The easiest way to avoid the kiddie tax is to shift earned income instead of unearned income. If your child works and earns wages through a legitimate job, especially one within a family-owned business, those earnings are taxed at the child’s ordinary income tax rate. In many cases, the first several thousand dollars may be tax-free due to the standard deduction.

You can also use earned income to fund a Roth IRA or pay tuition directly. Not only does this avoid the kiddie tax altogether, but it also provides your student with valuable work experience and helps keep more money in the family.

If you’re transferring assets to generate income, it’s essential to review the strategy first. In some cases, shifting ownership to other relatives (like a grandparent) or adjusting the investment mix may help reduce exposure to the kiddie tax.

Know When to Shift and When Not To

Shifting income to a child can be a powerful strategy, but only when you’re clear on how the kiddie tax works. For high-income parents trying to make college more affordable, avoiding unnecessary taxation is just as important as saving in the first place. When done carelessly, what appears to be a smart move on paper can become an expensive mistake in practice.

Our Freshman course shows you how to build a college funding plan that avoids costly errors like the kiddie tax and reveals where to find $10,000–$25,000 (or more) in hidden savings using legal, IRS-approved strategies.

Enroll today and make your money work smarter for your student’s future.