The recently-passed tax law raises the age for which the "kiddie tax" applies from under 14 to under 18 years of age. That means that investment income for children ages 14 through 17 are now suddenly taxed at their parent's tax bracket. Without planning, kiddie tax can wreck havoc to a college savings plan. Plans to sell appreciated securities set aside for college when a child turns 14, especially in cases of stock with low carryover basis in gift situations, need to be revised. Especially painful is the loss of an anticipated non-kiddie tax sale when the capital gains tax rate for lower income taxpayers will be zero percent in 2008, 2009 and 2010. (Taxpayers in either the 10 or 15 percent income tax bracket in 2008 through 2010 pay zero dollars on long-term capital gains recognized in those years.) Planning techniques to cope with the extended kiddie tax include the following: investing in long-term assets for capital appreciation after the child turns 18 rather than annual income in the years before; contributing to tax-deferred or Roth IRAs if the child has earned income for a part-time or summer job; and relying more heavily on Section 529 plans and Coverdell education savings accounts to save for college. In addition, many parents who had been planning to use the over-13 kiddie tax rule to save for college are now using the over-17 kiddie tax rule to save for graduate school. Others who need to use the funds sooner for college plan to hold on to appreciated securities while allocating some of their own portfolio to more secure investments to hedge any significant market risk. Those who are most impacted by the new law, however, are those 14 to 17 year olds who had their appreciated securities sold earlier in 2006, before the kiddie tax law was changed. Despite the retroactive effect of the new law to all sales on or after January 1, 2006, capital gains will be taxed at the parents' maximum 15 percent rate rather than the teenager's anticipated 5 percent rate. The sales are irrevocable and the new tax law offers no relief.

.	.
Children under 18 (14 before 2006) who have investment income above a threshold amount have to pay tax at their parents' rates. At one time, wealthy families could save a great deal of money by transferring investment assets to minor children. Tens of thousands of dollars in investment income produced by those assets would be taxed to the children at the lower rates that apply to individuals who have relatively little income. Congress decided to limit the tax benefit from shifting income to children, so we now have a law that says children under 18 who have more than a small amount of investment income have to pay tax at their parents' tax rate. Tax pros call this rule the kiddie tax. The age limit for this tax used to be 14, but beginning in 2006 it is 18. Income Threshold You don't have to worry about this rule until your child has investment income greater than a threshold amount, which is two times the amount allowed as a standard deduction for a dependent who has only investment income. For 2006, that amount is $850, so the kiddie tax begins to apply when your child has more than $1,700 in investment income. Your child can still owe regular income tax with less than $1,700 in income. This is merely the threshold amount of investment income for the special kiddie tax. Age 18 The rule does not apply if your child reached age 18 by the end of the year. (Before 2006 the rule applied until age 14.) For purposes of this rule, a child born January 1 is considered age 18 on December 31 of the year preceding the 18th birthday. As a result, a child 18 or older gets the full benefit of the lower tax rates, even when investment income exceeds the threshold amount. Married Filing Jointly When Congress raised the age limit for the kiddie tax to 18 in 2006, they added a provision saying it won't apply if the child is married and filing a joint return. How It Works If your child has more than $1,700 in investment income, the tax is figured according to a special calculation. The first $1,700 of investment income is still taxed at the child's lower rates, but any additional investment income is taxed at the parents' rates. Example: In 2006 your child has $2,700 of interest income and no other income. The first $850 of investment income escapes taxation: your child's standard deduction takes care of that. The next $850 is taxed at the child's rate of 10%. That leaves $1,000 to be taxed at whatever rate would apply if this income were added to the income reported on your tax return. Suppose you're in the 28% tax bracket. The tax on your child's income would be 10% of $850 plus 28% of $1,000, for a total of $365. Even though the tax is calculated at the parents' rate, it is still the child that owes the tax not the parents. How to Report There are two ways to apply the parents' rate to the child's income. One is to include the income on the parents' return. This option isn't always available, or you may decide it isn't best for you even if it is available. The other way is to report the income on a return for the child but with a special calculation on IRS Form 8615 (click for form and instructions).  Additional guidance is available in IRS Publication 929, Tax Rules for Children and Dependents.
The cost of education continues to rise at a rate exceeding the general inflation rate. The use of certain tax-friendly strategies can help families meet this ever-increasing expense. Qualified Tuition Programs (QTPs) Also called “529 plans” in reference to the Internal Revenue Code section that authorizes them, QTPs are primarily state-sponsored. There are two types: Prepaid tuition plans - tuition credits or certificates are purchased on behalf of a designated beneficiary (the child) College savings plans - contributions are made to an investment account set up for the beneficiary's college education expenses QTP contributions are not federal tax deductible. However, earnings can accumulate in the QTP free of federal income tax until the child is ready to start college. Then distributions from the QTP are tax free as long as they do not exceed the student's “qualified” higher education expenses for the year (including tuition, books, fees, supplies, required equipment, and room and board for students enrolled at least half-time). Contributions to a 529 plan are treated as gifts to the student, but gifts up to the annual exclusion amount ($12,000 for 2006) are not taxable. If contributions for one year exceed the exclusion amount, the contributor can elect to take them into account ratably over a five-year period. Thus, it's possible to fund a QTP on a gift-tax-free basis with as much as $60,000 in one year ($120,000 if contributed by a married couple). Coverdell Education Savings Accounts (ESAs) A second option is the ESA — an account that offers income-tax benefits similar to those available with a 529 plan. Unlike a 529 account, however, an ESA can be used to pay elementary and secondary school expenses as well as college costs. There is a $2,000 per year, per beneficiary limit on ESA contributions, and income restrictions apply. Prepayment of Tuition Prepaying tuition for private school or college is becoming more common these days, and the IRS has looked upon this education funding approach with approval. Tuition prepayment is a way for individuals with available funds to reduce the value of their estates while helping out grandchildren or other young relatives with their education expenses. If properly arranged, a payment made directly to an educational institution for multiple years of tuition can avoid both gift and generation-skipping transfer taxes. The $12,000 gift-tax annual exclusion would still be available for other gifts to the child that year. Need help with kiddie tax for your 2006 tax planning?  We can review the tax issues with you in more detail if you are interested in pursuing any of these options. Contact our office to set up an appointment for a one on one tax planning consultation.