By: Richard Feldman, MBA, CFP®, AIF®
Income shifting between parents and children has long been a strategy of affluent and even middle class parents to reduce taxes and help children accumulate assets to pay for college. Starting in 2008 this strategy will take a direct hit with updated rules for the so called “kiddie Tax” taking effect. Earlier this year George W. Bush signed the Iraq spending bill that included new rules for the “Kiddie Tax” that will effectively change the rules governing income shifting between parents and children.
Review of the Kiddie Tax Laws
The “Kiddie Tax” was originally established to prevent affluent families from using the strategy of shifting unearned income to their children who typically were taxed at much lower rates. Until 2005 the tax on a child’s unearned income (Dividends, Interest, Capital Gains) was taxed at the parents marginal tax bracket if the child was under the age of 14. The age limit was raised last year requiring children under the age of 18 to be taxed at their parent’s rate.
New Kiddie Tax Rules
The new edition of the Kiddie Tax rules are a result of the reduction of capital gains taxes to 15% for individuals and 5% for individuals who are in the lowest two tax brackets (10% and 15%). In addition, starting in 2008 through 2010, individuals who are in the 10% and 15% tax brackets would pay nothing on capital gains – that is right the tax goes to zero. Congress woke up and realized that the new capital gains rate structure will help out many individuals and families that it was not intended to help – children that are in low tax brackets that have wealthy parents. The reduction of capital gains down to zero from 2008 through 2010 would provide a bonanza to affluent families who planned properly and used the Kiddie Tax rules to their benefit. The new Kiddie Tax rules are designed to offset this strategy.
Starting in 2008, Kiddie Tax rules are expanded to include children up to age 19 or 24, if they’re full-time students and dependent on their parents. Children who provide more than half of their own support are not affected by the Kiddie Tax.
To follow are the Kiddie Tax rules on unearned income:
Unearned income rule: The Kiddie Tax will take affect if children have unearned income that exceeds $1,700 for 2007 ($1,800 for 2008). The first $850 is tax free and the next $850 is taxed at the child’s rate. Any amount over $1,700 will be taxed at the parent’s rate.
Planning Opportunities for 2007
For 2007 the Kiddie Tax rules can only apply if your child is under the age of 18 at year end. If your child is over 18 or over as of December 31st the Kiddie Tax rules won’t be an issue and you will be able to take advantage of your child’s reduced capital gains rates (assuming they are in the 10% or 15% bracket). Parents with highly appreciated stock that need to pay for college might consider gifting the appreciated stock to their children and have them sell it at the reduced capital gains rates. You can gift up to $24,000 ($12,000 per parent) without triggering any gift tax.
In addition gifting tax sensitive investments to children won’t cause Kiddie Tax problems. The following investments would be tax sensitive and allow you tonot be affected by the Kiddie Tax: Tax free interest on Municipals, Series EE U.S. Savings Bonds that are not cashed in while during Kiddie Tax years, and index and tax managed mutual funds that throw off little or no dividends and capital gains. These investments could then be sold when the child is either, over 18, and not attending college or over age 24 and just graduating college and in a low tax bracket.
This article is not intended to provide tax advice. Each individual or family’s situation is different so please consult a tax advisor to find out how the Kiddie Tax issue might affect you.
Congress Closes Upcoming Tax Break
By: Richard Feldman, MBA, CFP®, AIF®