What Does The Change In The "Kiddie Tax" Do For College Savings?

Volume 6 Issue 2006

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.