Understanding the Kiddie Tax

Here's how the income-shifting strategy generally works, ignoring the Kiddie Tax: You make cash gifts to your child's custodial account and then invest the money on the kid's behalf in stocks, mutual funds, T-Bills, and the like. Since your child is considered the legal owner of the custodial account, the income and gains from the assets in it are taxed to the child at his or her low rates — usually only 10% or 15% for ordinary income from interest and short-term capital gains and 5% or less for long-term capital gains and dividends. That's a big difference from the tax rates that high-bracket parents pay, which can run as high as 35% on ordinary income and 15% on long-term gains and dividends.

While income-shifting is usually reserved for affluent families, we can all appreciate the tax-saving idea. All of us except for Congress, that is. They created the Kiddie Tax rules to discourage the income-shifting strategy by taxing some of your child's investment income at your higher marginal rates. To make matters worse, the Kiddie Tax rules have become even harder to avoid due to unfavorable law changes in 2006 and 2007.

That said, there are still ways to work around these rules (more on that later). Also, you should understand that the Kiddie Tax only applies to so-called unearned income. This generally means investment income and capital gains (more rarely, it can also include certain royalties, income from a passive ownership interest in a parent's business, and other income items). If your child generates earned income from jobs or self-employment, that income will be exempt from the Kiddie Tax and taxed at your child's rates, which will almost always be 15% or lower. Finally, the Kiddie Tax won't apply to any year when your child files jointly with a spouse, nor will it apply if your marginal federal income tax rate is the same or lower than your child's.

Here are some other key aspects of how the Kiddie Tax rules work.

New age rules for 2008 and beyond: Starting in 2008, the Kiddie Tax can potentially apply up until the year when your child turns 24. Put another way, the Kiddie Tax will never affect a child who is 24 or older at year-end. For a child who is 19 to 23 years old, the Kiddie Tax can only apply if he or she is a student. More on that later.

Unearned income rule: The Kiddie Tax can only apply if your child has unearned income that exceeds the threshold, which is $1,700 for 2007 (probably $1,800 for 2008). If the unearned income doesn't exceed the threshold, then it will be taxed at the child's low rates. If the threshold is surpassed, only the unearned income in excess of that threshold is taxed at the parent's higher rates. In any case, the Kiddie Tax can't hit more than the amount of your child's taxable income after subtracting any applicable write-offs (such as the standard deduction) on the kid's Form 1040. When only a relatively small amount of your child's unearned income is hit with the Kiddie Tax, you can still reap meaningful tax savings by shifting some investment income to your child. In other words, you don't have to completely defeat the Kiddie Tax rules in order to make income-shifting worthwhile.

Here are some possible scenarios for 2007.

Example 1: Child is subject to Kiddie Tax in 2007
Say your unmarried daughter is 17 on Dec. 31 of this year. She'll be hit with the Kiddie Tax for 2007 if her unearned income exceeds $1,700, and she has positive taxable income after subtracting any applicable deductions. It makes no difference whether or not she's claimed as a dependent on your return for 2007.

Example 2: Child is Kiddie-Tax-exempt in 2007 due to age
Say your unmarried son is 18 or older at year-end. He's exempt from the Kiddie Tax for 2007 due to his age. But for 2008 and beyond, he may not be exempt. Stricter rules apply for those years.

Under age 18 at year-end: If your child is 17 or younger on Dec. 31, the Kiddie Tax will apply if he or she has unearned income above the threshold for the year (probably $1,800 for 2008) and positive taxable income after subtracting any applicable deductions. It makes no difference whether or not the kid is claimed as a dependent on your return. So in this age category, the rules are the same as for 2006 and 2007.

Age 18 at year-end: If your child is 18 at the end of the year and doesn't have earned income that exceeds half of his or her support the Kiddie Tax will apply if the child has unearned income above the threshold for the year and has positive taxable income after subtracting any deductions. Again, it makes no difference whether or not the kid is claimed as a dependent on your return.

Age 19 to 23 at year-end and a student: Let's say your child is somewhere between age 19 and 23 at year-end and is a student who doesn't have earned income that exceeds half of his or her support. The Kiddie Tax will apply if the child has unearned income above the threshold for the year and positive taxable income after subtracting for deductions. To be considered a student, the child must attend school full time during at least five months of the year. It makes no difference whether or not the kid is claimed as a dependent on your return. Bottom line: As ridiculous as it may seem, starting in 2008, some graduate students will be hit with the Kiddie Tax.

Here are some possible scenarios for 2008 and beyond.

Example 3: Over age 18 and not a student
Your unmarried daughter is 19 at the end of 2008 and isn't a student for the year. For 2008, she's exempt from the Kiddie Tax. Her unearned income for 2008 will be taxed at her lower rates.

Example 4: Over age 18 and a student
Your unmarried son is 23 at the end of 2008 and a graduate student for the year. He doesn't have earned income that exceeds half of his support. Therefore, he'll be hit by the Kiddie Tax if he has unearned income above the threshold and positive taxable income after subtracting any applicable deductions on his 2008 Form 1040.

Example 5: Year of graduation
Your unmarried daughter is 23 at the end of 2008. She's considered a student because she attends school full time during the first five months of the year before graduating in May. However, she starts a job in June and therefore has earned income in excess of 50% of her support for 2008. Thanks to that earned income, she's exempt from the Kiddie Tax for 2008, and all of her unearned income will be taxed at her lower rates.

For example, 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 cashed in when your child is Kiddie-Tax-exempt (say in the year of college graduation). The same goes if capital gains from your child's investments in growth stocks and tax-efficient mutual funds can be postponed until a Kiddie-Tax-exempt year. Life insurance products with investment accounts can also be used to dodge the Kiddie Tax. These are just a few ideas. Well-informed tax advisors can suggest additional Kiddie Tax avoidance strategies.

Finally, parents that use income-shifting to save money for their child's college education can generally avoid Kiddie Tax worries by using a Section 529 plan account or a Coverdell education savings account to accumulate college funds. Given the stricter Kiddie Tax rules that take effect in 2008, these accounts are more attractive than ever.