Kiddie Tax Laws
What is the Kiddie Tax Law?
The so-called kiddie tax (i.e., a tax on children's investment income at their parents' tax rate) keeps this family income-shifting strategy from working for children under a certain age. The kiddie tax subjects all but a small amount of the unearned income of a child to tax at his or her parents' marginal tax rate. For 2007, the kiddie tax applies to children under age 18 as of the end of the tax year. Beginning in 2008 (based on a new law signed in May 2007), the kiddie tax will also apply to children who are 18 years old or who are full-time students over age 18 but under age 24, if the child's earned income does not exceed one-half of the amount of their support.
Kiddie Tax Law - limited standard deduction
At the heart of the issue is the fact that kids--dependent children--enjoy a special “limited standard deduction” on unearned income, or income derived from investments: interest, dividends, and capital gains. In 2008 the first $900 of a dependent child's (below the age of 19, or 24 if a full-time student) investment income is tax-free, and the next $900 is taxed at the child's rate, which is typically 10%. So if your kids each earned $1,800 or less in investment-related income in 2008 and didn’t have additional earned income, each would pay $90 at most in tax (10% on the second $900), and perhaps no tax at all if that income was in the form of long-term capital gains or qualified dividends (this is a special tax break for 2008-2010; see below). If a child earns more than $1,800, any excess is taxed at the parent's marginal rate.
In order to save for their child's college costs, parents open accounts in the child's name. Not only does this designate the fund for the youngster's use, but it also had the tax advantage of having the earnings taxed at the youth's usually lower rate. That changed in 2006.
Kiddie Tax changes used for Federal Programs
In an effort to raise money to pay for other federal programs, Congress changed the child investment earnings rules, popularly known as the kiddie tax, last May. The change, however, was made retroactive to all transactions since January 1, 2006.
Cutoff Age Raised from 14 to 18
Previously, when an account was held in a child's name, any earnings exceeding an annual threshold amount $1,700 in 2006 were taxed at the parents' highest marginal tax rate. But when the child turned 14, his or her usually lower tax rates applied. Now, however, the cutoff age is 18, meaning the higher adult tax rates apply for additional four years.
Your highest marginal rate will be applied to the investment income of your children. So if you're in the 25% or 30% marginal rate, that's what will apply to the investment income instead of the 15% capital gains rate.
In essence, families who had utilized this tax strategy now lose not only the lower capital gains rates that would normally have applied to most long-term investment transactions, but also the benefit of the child's lower rates for any short-term profits. The excess child's investment income is essentially taxed at his or her parents' higher tax rates.
Kiddie Tax Law Dates
Compounding the problem is the date shifting of the law's effective date. People who made a move this year -- rebalanced the portfolio because the youngster is closer to college or they sold assets held by the child to pay for tuition -- they are going to owe more.
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