A question we hear quite often during tax season relates to when it is necessary to file a tax return for a dependent child. Some people think that money held in an account intended for college education is exempt from taxation. That is not the case, unless the account is an Education IRA or Section 529 plan. If the investments are held in a custodial account or held in the child’s individual name, the child is deemed the owner and the income is attributable to him/her.
To determine whether a return is required for a dependent, you need to know how much total income was earned during the year. The IRS then distinguishes the income between earned and unearned income. Earned income is from W-2 wages or self-employment income. The most common unearned income is interest, dividends and capital gains.
For filing year 2011, if the child only has unearned income and it is less than $950, then a return is not required. However, a return is required if an investment is sold and the gross proceeds plus interest and dividends are more than $950. Brokerage firms, banks, etc., report gross proceeds from investment sales to the IRS. The IRS assumes the entire sale is a capital gain. It is only when a return is filed that you can deduct the cost basis of the investment to establish your actual gain.
If the child only has income from working, then a return is not required if the total work earnings are less than $5,800.
The child needs to file a return for 2011 is he/she has income from both earned and unearned sources and the gross income exceeds the larger of (1) $950 or (2) the earned income up to $5,500 plus $300 (total here cannot exceed $5,800).
An election is available for the parent of a dependent child who is under age 24 at the end of 2011 to pay the child’s tax on the parent’s individual tax return instead of filing a separate return for the child. A few conditions [the child must be a full time student and their earned income must be less than 50% of their support] must be met to be eligible. The election usually results in higher overall taxes, but can save on tax preparation costs.