New Kiddie Tax Rules: Implications and Strategies

In last month’s visit I pointed out that the kiddie tax rules changed recently and would change again soon. The amendment occurred sooner than expected. The tax changes were put in the Iraq War funding bill in May (along with an increase in the minimum wage), and the details make the Kiddie Tax more restrictive than anticipated.

For 2007, the Kiddie Tax says that for a child under age 18, investment income above $1,700 for the year is taxed at the higher of the child’s tax rate and the parents’ highest tax rate. (Previously, the Kiddie Tax applied only to dependents under age 14.)

The new law is both broader and more complicated.

The general rule is that starting in 2008 the Kiddie Tax will apply one year longer-to children who are 18 or younger. The tax also will apply to children under age 24 who are full-time students. There is an exception for children with jobs; the new age limits do not apply if the child’s earned income exceeds half of the child’s support for the year.

The new law was enacted primarily to counteract part of the 2003 tax law. Under that law, in 2008 only taxpayers in the lowest two tax brackets (10% and 15%) face a 0% tax bracket on long-term capital gains realized in that year. They normally face a 5% rate. Congress believed the provision was enacted to help lower-income adults. But upper-income families have planned to make gifts of appreciated stocks and mutual funds to children so that the children could sell them and pay no taxes on the capital gains in 2008. (Gifts of up to $12,000 annually per donor are exempt from gift taxes.)

The new law effectively ends that strategy for most families. If the child is over 18 and not a full time student, the strategy still will work. Gifts of appreciated securities also can be useful in 2008 if made to parents and other relatives in low tax brackets, since the Kiddie Tax applies only to children. If gifts already have been made to children who will be full-time students or under age 19, consider having them sell the property in 2007. They will qualify for the 5% long-term capital gains rate in 2007 instead of having the new Kiddie Tax impose the parents’ rate in 2008.

Taxpayers who have not already done so should revise their family tax planning in light of these changes.

For some years we have been pointing out the potential disadvantages of making gifts to young children. The gifts can reduce the financial aid available to the child, more so than if the assets were retained in the parents’ names. In addition, most gifts are made through Uniform Gifts to Minors Act (UGMA) accounts. These have the disadvantage of giving the child full ownership of the property at the age of majority, which is 18 in most states.

The new Kiddie Tax adds to the disadvantages of gifts to children by dramatically reducing the tax advantages of gifts to minor children, except when the family is wealthy enough to set up trusts to hold and manage the gifts.

Here are other strategies families should consider for paying for the college education of children or otherwise helping them.

• Hold the investments in the parents’ or grandparents’ accounts. This avoids problems with the financial aid formula and with the child misusing the money. The accounts can be managed so they generate little or no taxable income until money needs to be spent. For example, stocks and mutual funds can be purchased and held for years. The long-term capital gains rate of 15% would be imposed. Tax-free bonds can be purchased instead of taxable alternatives.

• Give the money to the children, but limit the income it generates. Investment income is imposed at the parents’ rate only when it exceeds $1,700 in 2007. (The amount is adjusted for inflation.) The account can be invested to minimize interest and dividends. Stocks and mutual funds should be sold only when cash is needed, and then only enough to meet the needs should be sold. This does not avoid the Kiddie Tax, but it defers the day when income and gains earned by the children will be taxed at the parents’ top rate.
• Consider a 529 college savings plan. The downside of these plans is that investment options often are limited, and there usually are fees above those on straight mutual fund investments. The accounts, however, are not counted against the child for financial aid purposes. The income and gains compound tax-deferred within the accounts, and distributions are tax free if used for qualified education expenses. In addition, the owner of the account can change the beneficiary or withdraw the account balance at any time. A bonus is that the account balance is not included in the contributor’s estate.A couple of years ago it appeared that many families would be able to reap tax savings by transferring appreciated assets to children who would be age 14 or over in 2008. Under the law in effect, those assets could be sold in 2008, and the gains would be tax free. Now, in most cases only the first $1,700 of gains will be tax free in 2008. The rest will be taxed at the parents’ tax rate. It is time for parents and grandparents to consider alternative strategies for family tax savings and wealth building.