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Beginning in 2006, the kiddie tax rules are much less favorable to minor children with investment income and their families. Unless the parent(s) of a child under the age of 18 (previously 14 prior to 2006) make a special election to include the child's income on a parent's return, the child's unearned income is taxed to the child at his or her parents' top marginal rate. The child is not allowed a personal exemption if he or she can be claimed as a dependent on his or her parents' return.
However, the child can use up to $850 for 2006 of his or her standard deduction to offset unearned income. Thus, only unearned income in excess of $1,700 for 2006 is taxed at the parents' top marginal rate. These amounts are indexed annually for inflation.
In computing the parents' top marginal rate, all unearned income of children under age under age 18 in 2006 in excess of $1,700 is added to the parents' otherwise taxable income. The result is that, in some circumstances, the unearned income of a child under age 18 may be taxed at the 35 percent rate, while the parents' top rate would otherwise (based on their actual income) be lower.
The Tax Increase Prevention and Reconciliation Act of 2005 raised the kiddie tax age threshold from 14 to 18. This provision is effective immediately, for the entire 2006 tax year. The change is part of the $20 billion in revenue raisers that help offset the $90 billion in newly enacted tax breaks.
This change seriously impacts some existing tax planning opportunities. Parents who had planned to sell a child's college stock portfolio after age 13 and before entering college have no opportunity now to accelerate that planning technique if the child is over 13. If the family was planning to postpone a sale until 2008, when the top rate for capital gains would be zero, that's a loss of 15 percentage points on the tax otherwise not due on the sale of stock or other portfolio assets.
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Save Money
These new tax rules can be an unexpected burden for many families saving for college. However, the following gift-giving strategies can help reduce or even eliminate the kiddie tax and cut the overall family tax bill:
- Buy Series EE bonds for the child and have the child elect to defer tax on the interest as it accrues.
- Invest the child's money in securities with low yields but strong appreciation potential. If the securities are retained until age 18 or later, appreciation during the child's younger years escapes the kiddie tax.
- Invest in raw land with appreciation potential. From the tax viewpoint, the land should be held until the child reaches age 18 or later.
- Buy cash-value life insurance. Inside build-up from the policy will accumulate tax-free.
- If the child is a beneficiary of a trust, coordinate trust income with income from outside of the trust. Although this is a less attractive option, one can still accumulate trust income up to the amount taxed to the trust at the 15 percent rate ($2,050 for tax years beginning in 2006).
- Place UGMA and Uniform Transfers to Minors Act (UTMA) funds in tax-exempt bonds until the child reaches age 18. Tax-exempt zero coupon bonds may be a particularly good way to avoid the kiddie tax and build a college fund. Another approach is to buy stripped municipal bonds.
- Buy market discount bonds for the child, keeping the current yield below $1,700 (for 2006) so that the kiddie tax will not apply. When the bond is redeemed (or sold) after the child reaches age 18, the built-in discount will be taxed at the child's rates.
- Set up a gift-giving program that keeps the child's unearned income below the $1,700 threshold until he or she reaches age 18. For example, a cash gift to a 10-year-old child of $9,000, earning interest at eight percent, could grow over $3,000 by the time the child reaches age 18, and each year's interest will not exceed $1,300. Thereafter, the parent can set aside larger amounts for the child and continue to achieve effective family income-splitting.
- Employ the child in the family business or in the performance of chores supporting the payment of earned income. The income can be sheltered by the standard deduction. Even a young child can perform compensable services.
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