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Overview of the Kiddie Tax and its Implications

By: Investor Solutions

By: Investor Solutions, Inc.

On May 17th 2006, Congress passed the Tax Increase Prevention and Reconciliation Act. One of the provisions of this Act increased the age of children subject to the Kiddie Tax from 14 to 18 years of age putting a damper on many parents’ plans to transfer wealth to their minor children. What is the Kiddie Tax? And what problem will this new rule pose for families? How can parents avoid the Kiddie Tax trap?

The Kiddie Tax was first signed into law in 1986 as a way to deter wealthy parents from transferring high yielding investments or appreciated assets to their children. Prior to 1986, parents avoided taxation on tax insensitive investments by shifting them to their children so that the investment income would be reported on the children’s return. Often children paid little or no tax as their income was offset by exemptions and deductions.

The Kiddie Tax eliminated this tax break. In 1986 the law was changed so that some of the child’s investment income would be taxed at the higher parental tax rate. The unfavourable tax rate applied until the child reached 14. After that birthday, taxation went back to the child’s rate.

Congress amended the law last year and increased the age children are subject to the Kiddie Tax to 18. This rule applies retroactively to all unearned income (i.e. interest and dividend income) paid since January 1st 2006. Children under 18 will be subject to the following tax schedule:

1) Unearned income or interest of $850 or less is not taxed

2) Unearned income of $851 to $1,700 is taxed at the child’s rate

3) Unearned income above $1,700 is taxed at the parent’s tax rate

4) Any income earned by the child (i.e. summer/part time job) is taxed at the minor’s rate

5) Once the child turns 18, all income (earned and unearned) is taxed at his or her rate

This Act poses several problems for families transferring assets to descendents. Most distressing of all, this new law is applied retroactively to all unearned income received since January 1st 2006. Parents will discover that the estimated tax paid to date on their children’s investment will be short as a portion of the earnings will no longer be taxed at their 15 year old’s tax rate. Or, imagine you’ve cashed in a bunch of savings bonds earlier this year when your child turned 15. Whether you like it or not the earnings from these instruments will be taxed at your tax rate not your minor child’s?

Likewise, some individuals may have chosen to use custodial accounts such as Uniformed Gift to Minors Act (UGMA) and Uniformed Transfer to Minors Act (UTMA) as a way of funding their children’s college education. Under the old rules, parents invested for long-term growth until the child reached the age of 15. The assets were then converted to lower risk, income-producing assets in preparation for college bills. The new Kiddie Tax rules has eliminated that period in which the assets can be comfortably converted. Parents are now faced the dilemma of either making the shift as planned (and incurring a higher tax burden) or adjusting their strategy to accommodate the new rules. The former implies maintaining the assets in a long-term growth strategy, running the risk of under-funding the college account if the equity markets experience a prolonged downswing prior to matriculation.

The new tax rule has made tax-deferred college savings accounts ever more attractive. One-way around the Kiddie Tax is to utilize tax-free college savings accounts such as the Coverdell Education Savings Accounts (the Education IRA) or 529 plans. The Education IRA can be used to pay for both qualified elementary and secondary school expenses as well as college expenses. Individuals make after-tax contributions to the account and the assets grow tax-free. The child can receive tax-free withdrawals in any year, including years after 2010, to the extent that he or she incurs qualified higher education expenses (QHEE). One drawback about this option is that the contributions are limited to $2,000, which may not satisfy certain parents funding goals.

Another alternative is transferring all or a portion of the assets in an existing custodial accounts to a 529-college plan. In the former, assets are withdrawn tax-free for all qualified higher education expenses. High income-producing investment strategies can be assumed without triggering a Kiddie tax. Be aware that 529 accounts can receive only cash, so assets in an UGMA/UTMA may have to be liquidated and any realized gain would be subject to capital gains tax. In light of the current interest rate environment, it might make sense to sell income-producing bonds that will generate little or no capital gains.

These are some ways to get around the kiddie tax but other strategies may also apply to your particular situation. I suggest seeking advice from a competent tax professional to identify the most appropriate strategy for your goals.