[View Article List] [Go Back]

The Kiddie Tax Continues to Grow

Under the new tax law passed earlier this year—the Small Business and Work Opportunity Tax Act of 2007—Congress extended the reach of the so-called “kiddie tax.” Now this onerous tax provision might begin to affect families with children well into their twenties.

Background: Normally, income is taxed to the person who receives it at his or her ordinary income tax rate. However, unearned income received by a child may be taxable at the top marginal tax rate of the child’s parents to the extent it exceeds an annual threshold. In other words, instead of being taxed at a child’s low tax rate (usually either 10% or 15%), the effective rate on the income may be as high as 35%.

The annual threshold is adjusted for inflation. For 2007, the limit is $1,700 (unchanged from 2006). The first $850 is tax-free; the next $850 is taxed at the 10% rate. Reminder: The tax only applies to unearned income (such as capital gains, dividends and interest). Any other income your child earns is exempt from the kiddie tax.

Prior to 2006, this kiddie tax provision only applied to children under the age of 14. Then a major tax law passed last year raised the age limit to age 18. Now the new law extends the kiddie tax to older children.

New tax rule: Beginning in 2008, the age limit is increased to age 19 or age 24 for full-time students. These higher age limits apply if the child doesn’t have earned income equal to half of his or her annual support. In other words, you can’t avoid the kiddie tax just because you are no longer claiming the child as your dependent.

Keeping this change in mind, here are several possible ways to reduce the impact of the kiddie tax.

*Monitor your child’s investment income. If you are careful to stay below the $1,700 fault line, you will not have any kiddie tax problems at tax return time. For instance, in 2008 you might buy CDs for the child that will not mature until 2009.

*Emphasize tax-deferred investments. Instead of investments that produce current income, shift more of your child’s portfolio into long-range vehicles such as growth stock. Similarly, if you buy U.S. Savings Bonds in the child’s name, he or she doesn’t have to pay any current tax.

*Switch some investment dollars into municipal bonds. Generally, there are no federal tax consequences for investments in municipal bonds or municipal bond funds. Reason: The income received is exempt from federal income tax.

*Employ your own child (assuming you’re in a position of authority). Since the wages are earned income, the kiddie tax doesn’t apply. Assuming the child is paid a reasonable amount for the services actually performed, the business can deduct his or her salary.

Despite the new law change, you may be able to avoid dire tax consequences with astute advance planning. Seek professional advice for your own family.

[View Article List] [Go Back]