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.

A parent may elect to include a child's income in the parent's income if:

If you report the child's income, you can't claim any deductions for the child, such as a higher standard deduction if the child was blind, the deduction for a penalty on early withdrawal of savings, or any itemized deductions such as investment expenses or charitable contributions.

• the child's income consists entirely of interest and dividends;
• the child's income does not exceed $8,500 for 2006;
• no estimated tax payments have been made in the name of the child; and
• the child is not subject to backup withholding.

The election must be made by the due date (including extensions) of the regular tax return.

If the election is made, the parent must pay added tax of up to $85 for 2006. The $85 or whatever lesser amount the parent is called upon to pay is only what the child would have had to pay on income that is in excess of $850 and less than $8,500 for 2006.

The new kiddie tax rules do have some advantages, though. One situation in which the election might produce significant tax savings is where the parent is, for example, in the 35 percent tax bracket and cannot deduct investment interest because he or she does not have enough investment income. The election should enable the parent to treat the child's income as the parent's own investment income so that the parent would be able to make use of the interest deduction. Charitable contribution deductions also may be increased.

Another benefit would be relief from having to file the complicated "kiddie tax" form (Form 8615, Tax for Children Under Age 14 With Investment Income of More Than $1,600), especially where more than one child is involved. However, the election involves filing Form 8814, Parents� Election to Report Child�s Interest and Dividends, with the parents� annual tax return.

On the negative side, including the child's income could result in a reduction in the parents' deduction for medical expenses, IRA contributions and casualty losses. Also, the income may increase family state income taxes that otherwise would not be payable absent the election.