Aging of the kiddie tax increases cost to parents
A potential tripling of taxes on kids' future nest eggs has some financial advisers and others in high dudgeon. Congress included the surprise expansion of the kiddie tax as a revenue raiser in tax cuts it passed last month.
Democratic Rep. Bill Pascrell of New Jersey has already proposed rescinding the expanded tax, which he says "will penalize students in order to extend more tax cuts to the wealthiest few."
Hold on. While some kids could face higher tax on their savings and investments—whether for college or not—the kiddie tax is aimed at a tax-avoiding maneuver originally cooked up by and most benefiting upper-income families.
The tax was enacted in 1986 to inhibit a tactic of shifting income from high-bracket parents to low-bracket children. The strategy puts investments in a child's name so that interest, capital gains, and dividends are taxed—if at all—at a child's presumably low rate of probably 10 percent or less, instead of at the parents' higher rate of up to 35 percent.
The kiddie tax can spoil the fun by taxing the investment income of young children at their parents' tax rate. For 2006, the kiddie tax kicks in on a child's investment income in excess of $1,700. (There's still a break for lesser amounts: The first $850 of income is generally tax free, and the next $850 is generally taxed at the child's rate.)
Here's the big change. Until now, once a child turned 14 his or her income was no longer subject to the kiddie tax. Income was taxed on the child's own return at the child's own tax rate, opening the way for increased amounts of low-taxed income. Now, the kiddie tax will generally apply until a child hits 18, greatly narrowing the tax-saving ploy of putting assets in a child's name.
Reality check: Legally, the assets are the kid's. Practically, they may remain under control of the parents. Tax preparer Lawrence Silverman of Weymouth, Mass., says few of his mostly middle-income clients ever use the tactic or see much benefit to it. He says there is a rationale for clamping down: "It is not really the kid's money. It is a way for the parents to avoid tax."
But there's an unfair rub. The change applies this year, with no allowance for planning begun under the old rules. Parents of a child hitting 14 in 2006 who sold stock in the child's name earlier this year expecting the child to owe a mere 5 percent capital-gains tax are stuck. In a typical scenario, the gain will most likely face tax at the parents' rate of 15 percent. Taxpayers who sold a child's shares this year should consider cashing out any of the child's losers so the losses can offset the gains, advises Bob Scharin, senior tax analyst at tax guide publisher RIA.
Also stuck are parents who planned to delay sales until 2008, expecting their 14-year-olds to escape any capital-gains tax when the rate hits zero for low-income filers. Previous plans to generate income starting this year for a teenager turning 14 could now backfire.
Future taxable income for a child under 18 can be moderated by focusing on growth stocks and holdings that pay modest interest or dividends. Worth looking at, says Scharin, are tax-managed mutual funds that minimize taxable payouts, tax-free municipal bonds, interest-deferred U.S. savings bonds, and unimproved real estate. Remember, it's not the size of a nest egg that triggers the kiddie tax but rather the yearly income thrown off.