In the past, parents found that they could lower their taxes by shifting unearned income into their children's names. This worked when the parents were in a higher tax bracket than their children. Congress closed this loophole by enacting a tax law known as the kiddie tax. The kiddie tax is a tax on unearned or investment income (generally, interest and dividend income) of a child who is under age 14 at the end of the tax year. If a child under 14 years of age has unearned income over $1,600 (in 2004), the income exceeding this $1,600 threshold will be taxed at the parents' highest marginal tax rate.

In some cases, a parent has the option of reporting the child's unearned income on his or her tax return. In other cases, the child must file his or her own return. Each method of filing has several advantages and disadvantages. Note that the kiddie tax rules apply regardless of whether the child is your dependent. Further, the definition of a child includes your legally adopted child and your stepchild.

You should note that a child who has significant tax exempt interest, or tax preferences or adjustments, may be subject to the alternative minimum tax.