Who Pays Taxes on a Custodial Account?

Parents establish investment accounts for their children for several reasons, including to secure future income, to provide a nest egg when they move out on their own or to help pay for their college education. In situations such as these, it can be difficult to decipher which person, the parent or the child, will have to pay federal taxes on the interest or dividends that the account earns. In addition, depending on the situation, the applicable tax rate may be either the child's or the parent's.

Interest or dividend income that a child receives from investment activities, even when that child is a minor whose parents maintain control of the account, is generally taxable to the child. Since most children are in a lower tax bracket than their parents, many parents prefer to file a return for the child and pay the tax at the lower rate. Parents should be careful, however, as there are situations which render parts of the income taxable at the parents' rate. In addition, there are circumstances under which it may be more financially practical to include a child's investment income with their own.

Parents may elect to report their child's custodial account income with their own. The income will be taxed at their rate instead of their child's, and it may push them into a higher tax bracket. In addition, the Internal Revenue Service disallows some deductions when parents include a child's unearned income with their own. To qualify for this election, the child must be less than 19 years old, or less than 24 years old and a full-time student. In addition, the child's income must be less than $10,000, no prepayments of the child's tax may be made throughout the year, and he cannot file a joint return for that year.

Children whose unearned income is less than $2,000 receive the first $1,000 tax-free and pay tax on the remainder at 10 percent. Therefore, if the child receives $1,470 in dividend and interest income for 2013, his taxes for the year are $47. Amounts in excess of $2,000 are taxable at the parent's tax rate. For example, if the child earns $3,675 in 2013and his parents are in the 28 percent tax bracket, then $,,675 is taxable at this rate.

Earned income, which is generally received in exchange for work performed, changes the amount of a child's taxable income. When a child's income is both earned and unearned, and the unearned portion exceeds $2,000, a portion of the unearned income is taxable at the parents' rate. earns both earned and unearned, or investment income, then a portion of the is taxable at the parents rate if the investment income exceeds $2,000. The calculations for determining that amount can be found in Section 31 of IRS Publication 17 (See Resources).