“KIDDIE TAX” EXPANDED THROUGH RECENT LEGISLATION

No doubt about it – kids are expensive. Recent legislation could result in the "kiddie tax" applying to children as old as 24. There are now more tax consequences for parents to consider. Parents should understand the new legislation and how it applies to saving for the future.

The "kiddie tax" was first introduced by the Tax Reform Act (TRA) of 1986. The "kiddie tax" specifies the age at which children become a separate taxable entity from their parents for purposes of calculating tax on investment income. The law was designed to prevent parents from exploiting a tax loophole when their children received large gifts of stock; the child would realize any gains from the investments and be taxed at a far lower rate as compared to the tax rate if the parents instead realized the stock's gains.

Under the TRA of 1986, children from birth to age 14 could earn investment income of up to two times the standard dependent deduction of $850 and be taxed at their tax rate, typically 10 percent. Any investment income over the threshold of $1,700 was taxed at the parent's presumably higher tax rate. After age 14, all investment income was taxed at the child's lower rate.

The Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005, passed by Congress and signed by President Bush on May 17, 2006, added a provision to keep the parent's tax rates in effect until a child turns 18. (A child is considered to be 18 for the entire tax year in which he or she turns 18.) In addition, under the Small Business and Work Opportunity Act of 2007, this tax can apply to full-time students under the age of 24 beginning in 2008.

To figure a child's tax, one must fill out Form 8615 and attach it to the child's federal income-tax return. However, parents may instead choose to report the child's investment income on their return. This is an option if a child's earnings are only from investment income and are less than $8,500. In this case, the child's investment income is detailed on Form 8814, "Parents' Election to Report Child's Interest and Dividends," and included with the parents' tax return. In this case, the child does not have to file a return or Form 8615.

It is important, however, to keep in mind that when a parent adds a child's income to their return the extra money could mean the loss (or at least a reduced benefit) of some tax deductions and credits that are phased out as income grows. One should run the numbers on both Form 8615 and Form 8814 to maximize the potential that the parent and the child pay the least possible tax on the child's investment earnings. If there is more than one child with unearned income, the process must be repeated for each child.

The new legislation puts the future of accounts established under Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) in question as well. Under these acts, individuals can place assets in accounts for the benefit of a child but retain control of the assets as the trustee until the child reached the age of majority, usually 18 or 21, if specified. The tax benefit of moving assets to a child's name may now be reduced as income invested in these accounts over $1,700 will be taxed at the parents' rate anyway.

Now that the "kiddie tax" applies to children through age 18, it makes even more sense to save for a child's college education either in the parent's name or within a 529 Plan or Coverdell Education Savings Account (ESA).

UGMA/UTMA assets can be transferred to a 529 College Savings Plan for the same child, but 529 accounts can receive only cash. Assets in an UGMA/UTMA may have to be liquidated and any realized gain would be subject to capital gains tax. Because UGMA/UTMA assets belong specifically to the child and 529 funds can be transferred to other family members, the account must be segmented. UGMA/UTMA assets within a 529 plan are not considered the property of the child for financial aid calculations.

With a capital gains rate of just 5% for kids in the 10% or 15% tax bracket, parents in higher brackets may still want to consider transferring appreciating assets. But, parents who thought they had the years between 14 and 18 to sell assets in their child's portfolio and potentially pay no capital gains tax have lost that option. Still, college students most often fall in a lower tax bracket than their parents, so selling after the child turns 18 will most likely mean less capital gains than if the parents had sold those assets. If the child is claimed as a dependent, it may be necessary to wait until the child completes college to take advantage of his/her lower tax bracket.

There are other variables to consider as well. Investments made in a child's name may reduce the amount of financial aid available to the family. In addition, if the child receives a full scholarship or decides not to go to college, any money saved in that child's name becomes his or her property upon reaching the age of majority in that particular state.

Parents have another option if there is concern that a child's college fund may grow large enough to trigger "kiddie tax" down the road. Cash out the custodial account and transfer the money to a state-sponsored 529 college-savings plan, which lets the savings grow tax-deferred. Distributions escape Federal taxes if used for qualified college expenses. If one is just starting to save for a child's education, the 529 plan wins out over custodial accounts. There is no Federal tax deduction for 529 contributions, but some states offer generally small tax breaks to residents.

To speak to someone directly, please contact Elaine Rulkiewicz at erulkiewicz@rubino.com. For more information about the firm, please visit http://www.rubino.com/ or call 301.564.3636.