Posted on Thu, Jan. 24, 2008
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'Kiddie tax' has turned into a parent penalty
'It has ruined wonderful planning'
By EILEEN PUTMAN
THE ASSOCIATED PRESS
MOST-READ STORIES
WASHINGTON --
If you have a child who turned 18 in 2007, you are in luck. But that's the only bright spot for families burdened by the "kiddie tax."The tax is, in effect, a penalty on parents who saved for their child's college by putting money into custodial accounts at a time when today's tax-free education savings vehicles weren't widely available or used.
"It has ruined wonderful planning people have been doing for years, people who were thinking ahead, who gave their child income-producing assets they would use when the kid went to school," said Harvey Aaron, senior tax manager at Braver PC in Newton, Mass. and director of tax services at Braver Wealth Management.
Here's how the kiddie tax works: If a child is under 18, he is allowed to have $1,700 in unearned income - non-wage income such as dividends and interest on investments - before the kiddie tax kicks in. (There's no tax on the child's income of $850 or less, and the next $850 in income is taxed at the child's ordinary income tax rate, usually 10 percent or 15 percent.)
For unearned income over $1,700, the child's tax is computed at the parent's tax rate, which can be as high as 35 percent. A child who turned 18 in 2007 isn't subject to the kiddie tax and will pay 2007 tax at his lower rate.
But Congress has raised the age at which children are subject to being taxed at the parents' rate. For 2008 income, the kiddie tax will apply to children under 19, and even those under 24 if they are full-time students and don't have earned income equal to half of their annual support.
Shifting income to children in lower tax brackets is a strategy long used by the wealthy to reduce their tax, and Congress took aim at that practice when it passed the kiddie tax nearly 20 years ago.
But the wealth-shifting strategy was also a way for middle-income parents to save for children's college expenses.
Nowadays, many parents choose as college savings vehicles the popular 529 plans, which allow earnings to grow tax-free when the money is used for higher education. But 529s weren't as widely available when parents of today's older teens started saving. Instead, those parents typically saved for college by putting money into custodial mutual funds, bonds or other savings instruments in the child's name.
It's the return on those investments - the "unearned" income that includes interest, dividends, rents, royalties and profits on the sale of property - that falls under the kiddie tax. The tax doesn't apply to wages a child earns at a job.
