By Dr. Jim Dahle, WCI Founder
I noticed something interesting in early 2023 as I did taxes for my kids. (I made them do the written tax forms themselves the year before as a learning experience, but it was easier to do it myself this time.) We generally file these easy returns by hand so it often provides those good learning experiences that I used to have from doing my own taxes. My kids don't really earn enough money to pay federal income taxes, but the thing I noticed in 2023 was that the more money my kids earned, the less they paid in state income tax here in Utah.
I thought, “Well, that's weird!” so I dug into it.
Why My Kids Don't Pay Federal Income Taxes
I have four kids; when I wrote this post, they were ages 7 to 18. They all had very similar tax situations. Three of their Uniform Transfer to Minors Accounts (UTMAs) had the exact same holdings, balance, and income, and the other one only had a slightly larger one. They all got paid exactly the same by The White Coat Investor ($3,500) for their modeling activities. However, they each had a different amount of additional earned income for that tax year:
- 7-year-old: $0
- 13-year-old: $40 in household employee income
- 16-year-old: $2,780 from a summer job
- 18-year-old: $4,885 from a summer/college job and perhaps $500 in self-employment income as a photographer
Their federal tax returns included Form 1040, Schedule 3 (for the foreign tax credit), Schedule B (ordinary dividends over $1,500), and Form 8995 (199A deduction from REIT income in the UTMAs). The eldest also filed Schedule C (business income) and Schedule D (because I hate myself, I tax-loss harvested her UTMA in 2008, and I have been filling this out ever since to carry forward the $399 in capital losses).
The reason my kids are required to file a federal tax return is not because of their earned income. As long as earned income is under $14,600 in 2024, a dependent child need not file a return. However, their unearned income in that UTMA was more than $1,150 (and their total income was more than their earned income plus $400), so they had to file a federal return even if they owed nothing (which is exactly what they owed, except for some payroll/self-employment taxes for the eldest's business income).
Why did my kids owe nothing to the feds? The standard deduction for a dependent is the lesser of $14,600 (the normal single standard deduction) or their earned income plus $400. So, their entire earned income was not taxable, and the last $400 of their unearned income was not taxable. The way unearned income is taxed for minor children in 2024 is that the first $1,300 is taxed at 0% (it was $1,150 when I wrote this post), and the next $1,300 is taxed at the child's tax rate. Anything above that is taxed at my tax rate.
The amount assessed at my tax rate is known as the “kiddie tax” and is the main reason UTMAs should be invested tax-efficiently (ours are split between total stock market (TSM) and total international stock market (TISM)) and kept to a limited size (less than $100,000 or so). Their qualified dividend tax bracket is 0% and their regular tax bracket is 10%. For my kids, their unearned income totaled $1,689-$1,802, of which over 80% were qualified dividends. The non-qualified dividends were $333-$356, which was more than wiped out by that free $400 in additional standard deduction. The taxable remainder ($1,689 – $1,150 – $400 = $139) was taxed at 0% because they were qualified dividends. Heck, they paid more than that in foreign taxes on their TISM investment ($89, the non-refundable credit did them no good). Thus, no federal income taxes were due unless they owed payroll/self-employment taxes (which one of them did).
More information here:
12 Things I Learned from Doing My Own Taxes as a Kid
How I Teach My Kids About Money
Why Is Utah So Mean to My Kids?
If they don't owe anything in federal income tax, why did they have to pay state income tax? It turns out that states do not calculate their tax bills the same way as the feds. The only reason these kids have to file a state tax return at all is that they were required to file a federal tax return, even though they didn't owe federal income taxes.
Utah charges a flat 4.85% tax. If you make $20,000, you pay 4.85%. If you make $2 million, you pay 4.85%. If you made your money as a business owner, it's 4.85%. As an employee, it's also 4.85%. In qualified dividends and long-term capital gains, it's 4.85%. In non-qualified dividends, interest, or short-term capital gains, yep, it's 4.85%. That part is pretty simple and generally a pretty good thing for people like doctors with high-earned income. Where it gets interesting is when they calculate their “standard deduction,” aka the “taxpayer tax credit.” It's not the same as the federal one.
The first thing you do on a Utah state income tax return is add up your total income. Then, you multiply it by 4.85% to get the amount of tax you owe. Easy, peasy, right? Except then you spend a few lines calculating this “taxpayer tax credit.”
You start with the federal standard deduction and add any exemptions you might have ($1,802 × the number of dependents, which is 0 for my kids). You multiply that by 6%. Why 6%? I have no idea. That's just how Utah does it—a tax rate of 4.85%, a credit rate of 6%. It then applies a phaseout on that credit that doesn't apply to very low earners like my kids. You take that amount and subtract it from the tax due.
In the case of my two youngest, they still owed $18 in tax. However, the two oldest owed nothing. Why not? Because a much higher percentage of their income was earned income, which resulted in a higher federal standard deduction. Their higher standard deduction multiplied by 6% made for a taxpayer tax credit that was larger than the tax due. Despite earning less money, the younger kids had to pay more in tax because a larger percentage of their earnings was from unearned income, even though the older kids had just as much (or more) unearned income.
Just a bizarre unintended consequence of trying to write fair tax laws. The bottom line is that the state of Utah wants to encourage work more than the US government, so it rewards those who work with more favorable tax treatment. Thus, the 7-year-old and 13-year-old were trying to figure out how to come up with the $18 they needed to pay their taxes (“I don't have any money Dad; you'll have to take me to the bank.”) It took me a while to tell them that I already wrote the checks myself.
There are lots of weird little things at the lower end of the tax brackets that you might not expect. They might be interesting, but they tend not to mean much. In this example, tax preparation is more about dealing with hassle than actually paying out any significant amount of money.
What do you think? What weird things have you noticed while filing tax returns for your kids?
You opened UTMA when you were still on active duty? I don’t recall that from early WCI posts. Good for you. I kind of thought you didn’t do it until you became ultra wealthy. I really didn’t feel like I had any extra money to give to my kids at that time. Maybe if I had been allowed to moonlight. But I still don’t, so maybe not.
Well, let me check the spreadsheet. Looks like my first ever UTMA contribution was September 2008, 2 years out of residency and while I was on active duty. It was $3,000.
I’m not sure of the exact definition of “ultra wealthy” but I see an “ultra high net worth” definition online that says it’s investable assets of $30 million. So I guess I’m still not ultra wealthy if that’s the definition.
I’d say we “got serious” about UTMA contributions in 2018, which is about when we became financially independent and the year after paying off the mortgage.
I have never given much thought to what I invest my kids’ UTMA accounts in. Each kids has about $85K in such an account. For tax efficiency, are you suggesting those be invested 100 percent in a stock index fund and not some combination of a tax fund and bond fund?
In Illinois the situation for kids is largely the opposite. For 2023 Illinois exemption allowance is $2,425. For dependents the rule is that if your Illinois base income (Federal AGI adjusted by state level additions and subtractions) is less than $2,425 you are entitled to one exemption and no Illinois tax is due. If a dependent is over $2,425 there is no exemption and Illinois tax must be paid from the first dollar of income. At our 4.95% tax rate this means that a dependent’s Illinois state tax instantly goes from zero to $120 with their 2,426th dollar of income (regardless of source).
By contrast the cliff for self-employment tax goes from zero to $61 with the 433rd dollar of net self-employment earnings.
Crazy cliff eh? An infinite marginal tax rate.