FINALLY SETTING UP
a college savings fund for your little one, huh? Then you've got to decide whether to put the account in her name, or in yours. And before you make that decision, you'll need to know the lowdown on the "kiddie" tax.
This meddlesome tax (which ones aren't, right?) was established in 1986 to catch rich parents who were trying to circumvent taxes on their investments by putting the investment assets in the names of their little children. The tax applies only to children under the age of 14. (After that, a child is taxed just like an adult.)
The kiddie tax allows a child under 14 to receive $650 in investment income (from interest, dividends or capital gains) free of tax. (The threshold was raised slightly by the Taxpayer Relief Act of 1997, which allows for annual increases in the income caps.) The next $650 is taxed at the child's rate -- presumably 15% for income and short-term capital gains, and 10% for long-term capital gains. Anything after that is taxed at the parents' rates, which can be as high as 39.6%. That means that $416 is the most you can save in taxes each year.
Here's what you give up for that savings. First, you lose control of the money once your child turns age 18 or 21, depending on your state. "If your kid decides he wants to skip college and ride a Harley around Europe for a year, he can take that money and go," warns Joan Chasen, a Framingham, Mass.-based fee-only financial planner. Second, you may be reducing your child's chances of getting financial aid. Here's why: Colleges will expect a child to contribute 35% of the assets in his or her own name to cover college expenses while parents are expected to contribute only 5.6% of theirs.
See our stories "Which IRA Is Best for You" and "The New College Tax Breaks Explained." "Every dollar you keep out of your adjusted income helps in terms of the myriad phaseouts in the new tax code," explains David Foster, a fee-only financial planner in Cincinnati. "If you take $50,000 and put it in your kid's name, you may have removed $5,000 [in interest income] from your 1040 and kept AGI under $150,000." Thus, you would just meet the cutoff for opening a Roth.
Once you decide to put assets in your child's name, there are a couple ways to minimize your exposure to the kiddie tax. One is to buy tax-exempt bonds or series EE U.S. savings bonds, the interest of which isn't taxed until maturity or redemption. You can wait until the kids have grown out of the kiddie tax to cash them in, and avoid the issue altogether. Or, if the interest on bonds is less than $650 annually, you can report that income every year and pay nothing. Then, when the bonds mature, you'll pay no taxes on them. But these tax-exempt investments won't provide the kind of capital appreciation you probably want in a college-savings account.
If that's the case, go for stock or equity mutual funds instead. Here, you can minimize your tax bill by buying index funds, which sell stocks infrequently and thus generate few taxable gains. There are also funds specifically designed to minimize taxable gains and income by carefully selecting shares to sell so that capital losses offset capital gains or encouraging long-term investing by assessing fees on the redemption of shares held for short periods, for example. If you buy individual equities, look for low-yielding stocks with the potential for lots of capital appreciation.