Planning Strategies for the Kiddie Tax
Years ago, Congress came up with the anti-taxpayer concept known as the Kiddie Tax. It's intended to discourage high-bracket parents from shifting taxable income (especially income from investments) to their lower-bracket children to reduce the family's combined federal income tax bill.
Ignoring the Kiddie Tax, the income-shifting strategy usually works like this: Over a period of years, you make cash gifts to your child's custodial account. The money is invested in stocks, mutual funds, bonds, and so forth. Since your child is considered to own the custodial account and its income and gains, they are taxed on your child's income tax return at his or her low rates-usually only 10% or 15% for ordinary income from interest and short-term capital gains and only 5% (maybe even 0%) for long-term capital gains and dividends. In contrast, your federal tax rate on ordinary income could be as high as 35%, and you probably pay the maximum 15% rate on long-term gains and dividends.
You may intend to use the money that accumulates in your child's custodial account to help pay for college. Obviously, if the account's income and gains are taxed at your kid's lower rates, there's that much more left to cover education costs. Great idea!
Unfortunately, Congress doesn't like the income-shifting concept because it reduces the government's tax receipts. Enter the Kiddie Tax rules. They are intended to prevent you from benefiting from the income-shifting strategy by taxing part of your child's investment income at your higher marginal rates. To make matters worse, the Kiddie Tax rules have become a moving target due to unfavorable law changes made last year and this year. However, all is not lost. With some advance planning, you can often minimize or even completely avoid the Kiddie Tax.
Kiddie Tax Basics
The first thing to understand is that the Kiddie Tax can only hit your child's unearned income. That generally means investment income such as dividends, interest, and capital gains. On the other hand, if your child has earned income from jobs or self-employment, it's completely exempt from the Kiddie Tax. Therefore, earned income will always be taxed at your child's federal income tax rates, which will almost always be 15% or lower. Also, the Kiddie Tax won't apply to any year when your child files jointly with her spouse, nor will it apply if your marginal federal income tax rate is the same or lower than your child's.Enough background! Let's now cover other key aspects of how the Kiddie Tax rules work after the recent law changes.
Your Child's Age and Unearned Income Are the Two Key Factors
Unearned Income Threshold. Fortunately, the Kiddie Tax can only hit your child if he or she has unearned income that exceeds the threshold for the year in question. This threshold, which is adjusted periodically for inflation, is $1,700 for 2007. For 2008, we expect it to go up to $1,800. If your child's unearned income for the year doesn't exceed the threshold, the Kiddie Tax simply doesn't apply, and all of your child's unearned income for that year will be taxed at his or her low rates.If your child's unearned income exceeds the threshold, only the excess amount can be hit with the Kiddie Tax. In other words, that excess amount can be taxed at your higher rates, but the rest of your child's unearned income will be taxed at his or her lower rates. When only a relatively small amount of a child's unearned income gets hit with the Kiddie Tax (thanks to the threshold), the tax savings from income shifting can still be substantial. This means you need not completely defeat the Kiddie Tax rules to make income-shifting a worthwhile idea. A partial victory can be good enough.
One more thing: No matter what, the Kiddie Tax cannot hit more than the amount of your child's taxable income after subtracting any allowable write-offs (such as the standard deduction) on his or her Form 1040. Therefore, strategies that reduce your child's overall taxable income can also reduce or eliminate the Kiddie Tax bite.
Age Rules. For 2007, the Kiddie Tax can only affect your child if he or she is under age 18 as of 12/31/07. So if your child is 18 or older, the Kiddie Tax simply won't be an issue this year. However, this ultra-simple age rule ends with this year.
Starting next year, the Kiddie Tax can potentially hit your child until the year when he or she turns age 24. However, it's not that simple. There are three different age categories beginning in 2008, and the rules are different for each.
- Under Age 18 at Year-end: If your child is age 17 or younger on December 31 of the year in question, the Kiddie Tax will apply if he or she has unearned income above the threshold for that year ($1,800 for 2008) and positive taxable income after subtracting any allowable write-offs (such as the standard deduction). (In this age category, the rules are actually the same as for 2007.)
- Age 18 at Year-end: If your child is age 18 at year-end and does not have earned income that exceeds half his or her support, the Kiddie Tax will hit if he or she has unearned income above the threshold ($1,800 for 2008) and positive taxable income after subtracting any allowable deductions.
- Age 19-23 at Year-end and Student: If your child is 19 through 23 at year-end and a student who doesn't have earned income that exceeds half of his or her support, the Kiddie Tax will apply if he or she has unearned income above the threshold ($1,800 for 2008) and positive taxable income after subtracting any allowable write-offs. Your child is considered to be a student if he or she attends school full-time during at least five months of the year. As you can see, some 23-year-old graduate students will probably be hit with the Kiddie Tax after 2007. Ridiculous, but true!
Example: Kiddie Tax May or May Not Apply in Year of College Graduation Your unmarried son is age 21 at the end of 2008. He is considered to be a student for that year because he attends school full-time during the first five months before graduating in May. However, he starts a job in June and is paid a salary that exceeds 50% of his support. Thanks to that salary, your son is exempt from the Kiddie Tax for 2008 and all of his unearned income will be taxed at his lower rates.
Variation: Now assume your son doesn't earn much money in 2008. He will be hit with the Kiddie Tax if his unearned income exceeds $1,800 and he has positive taxable income after subtracting any allowable deductions on his Form 1040.
Kiddie Tax Avoidance Strategy for 2007
As we explained earlier, a child who is 18 or older as of 12/31/07 cannot be hit with the Kiddie Tax for 2007. However, under the stricter new rules starting in 2008, the Kiddie Tax can potentially hit a student who will be age 19-23. Therefore, your child could be exempt from the Kiddie Tax in 2007 (because he or she is 18 or older on 12/31/07) and still be a Kiddie Tax victim in 2008 and later years (because she will be a student age 19-23 in those years). The good news is that this situation creates a one-time tax planning opportunity for this year.Say your child will be between age 18-22 on 12/31/07 and a full-time student next year. If so, consider having your child trigger some additional taxable gains (say from selling some stock) and other taxable income (say from cashing in some U.S. Series EE Savings Bonds) before the end of this year. Since the Kiddie Tax won't apply this year, those gains and income will be taxed at your child's rates. What will those rates be? Probably only 5% for long-term capital gains and dividends and only 10% or 15% for ordinary income which can include interest and short-term capital gains. By following this strategy, there will be less gains and income to be hit with higher Kiddie Tax rates after 2007.
Kiddie Tax Avoidance Strategies after 2007
Despite the stricter rules starting in 2008, the Kiddie Tax threat can often be neutralized by selecting the right investments, taking advantage of the annual unearned income threshold, and maximizing earned income.For instance, tax-free interest from municipal bonds won't cause Kiddie Tax problems. Accumulated interest from Series EE U.S. Savings Bonds won't be hit with the Kiddie Tax if the bonds are not cashed in until a year when your child is exempt from the Kiddie Tax (perhaps in the year when he or she graduates from college). Capital gains from growth stocks and tax-efficient mutual funds can be managed to stay at or near the annual unearned income threshold with remaining gains postponed until a year when your child is exempt from the Kiddie Tax. Life insurance products with investment accounts can also be used to avoid the Kiddie Tax. College savers can generally avoid Kiddie Tax problems by investing in Section 529 accounts or Coverdell education savings accounts. The stricter Kiddie Tax rules that take effect next year make these accounts more attractive.
If you operate a business that can hire the child, the resulting extra earned income could be just what the doctor ordered. Even if the child's earned income doesn't exceed half of his or her support, it can still have other beneficial side effects These are just a few ideas. We can help tailor a Kiddie Tax avoidance strategy that's appropriate for your specific family situation.
