February 1, 2008
Dear Clients,
Years ago, Congress came up with the anti-taxpayer concept known as the Kiddie Tax. It’s intended to discourage high-bracket taxable income parents from shifting taxable income (especially income from investments) to their lower-bracket children to reduce the family’s combined federal income tax bill.
Without the Kiddie Tax, the income-shifting strategy usually works like this: Over a period of years, you make cash gifts to your child’s custodial account. The money is invested in stocks, mutual funds, bonds, and so forth. Since your child is considered to own the custodial account and its income and gains, they are taxed on your child’s income tax return at his or her low rates—usually only 10% or 15% for ordinary income from interest and short-term capital gains and only 5% (maybe even 0%) for long-term capital gains and dividends. In contrast, your federal tax rate on ordinary income could be as high as 35%, and you probably pay the maximum 15% rate on long-term gains and dividends.
Kiddie Tax Basics
The first thing to understand is that the Kiddie Tax can only hit your child’s unearned income. That generally means investment income such as dividends, interest, and capital gains. On the other hand, if your child has earned income from jobs, it’s completely exempt from the Kiddie Tax. Therefore, earned income will always be taxed at your child’s federal income tax rates, which will almost always be 15% or lower. Also, the Kiddie Tax won’t apply to any year when your child files jointly with his or her spouse, nor will it apply if your marginal federal income tax rate is the same or lower than your child’s.
Your Child’s Age and Unearned Income Are the Two Key Factors
1. Unearned Income Threshold
Fortunately, the Kiddie Tax can only hit your child if he or she has unearned income that exceeds the threshold for the year in question. For 2008, we expected this threshold, which is adjusted periodically for inflation, to increase to $1,800. If your child’s unearned income for the year doesn’t exceed the threshold, the Kiddie Tax simply doesn’t apply, and all of your child’s unearned income for the year will be taxed at his or her low rates.
If your child’s unearned income exceeds the threshold, only the excess amount can be hit with the Kiddie Tax. In other words, that excess amount can be taxed at your higher rates, but the rest of your child’s unearned income will be taxed at his or her lower rates. When only a relatively small amount of a child’s unearned income applies to the Kiddie Tax, the tax savings from income shifting can still be substantial (approximately $720 computed at $1,800 of unearned income x 40% federal and state income tax brackets).
2. Age Rules
Starting this year, the Kiddie Tax can potentially be assessed to your child until the year when he or she turns age 24. There are three different age categories beginning in 2008, and the rules are different for each.
A. Under Age 18 at Year-end: If your child is age 17 or younger on December 31 of the year in question, the Kiddie Tax will apply if he or she has unearned income above the threshold for that year ($1,800 for 2008) and positive taxable income after subtracting any allowable write-offs (such as the standard deduction).
B. Age 18 at Year-end: If your child is age 18 at year-end and does not have earned income that exceeds 50% of his or her support, the Kiddie Tax will apply if he or she has unearned income above the threshold ($1,800 for 2008) and positive taxable income after subtracting any allowable deductions.
C. Age 19-23 at Year-end and Student: If your child is 19 through 23 at year-end and a student who doesn’t have earned income that exceeds half his or her support, the Kiddie Tax will apply if he or she has unearned income above the threshold ($1,800 for 2008) and positive taxable income after subtracting any allowable write-offs. Your child is considered to be a student if he or she attends school full-time during at least five months of the year. As you can see, some 23-year-old graduate students will probably be hit with the Kiddie Tax in 2008 or after.
Note: A child can be subject to the Kiddie Tax even if you do not claim the child as a dependent on your Form 1040.
Kiddie Tax Avoidance Strategies in 2008 and Thereafter
Despite the stricter rules starting in 2008, the Kiddie Tax threat can often be neutralized by selecting the right investments, taking advantage of the annual unearned income threshold, and maximizing earned income.
For instance, 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 not cashed in until a year when your child is exempt from the Kiddie Tax (perhaps in the year when he or she graduates from college). Capital gains from growth stocks and tax-efficient mutual funds can be managed to stay at or near the annual unearned income threshold ($1,800 in 2008) with remaining gains postponed until a year when your child is exempt from the Kiddie Tax. College savers can generally avoid Kiddie Tax problems by investing in Section 529 accounts or Coverdell education savings accounts. The stricter Kiddie Tax rules that take effect in 2008 make these accounts more attractive.
If you operate a business that can hire the child, the resulting extra earned income could help the child’s earned income exceed ½ of parental support.
These are just a few ideas. We can help tailor a Kiddie Tax avoidance strategy that’s appropriate for your specific family situation.
Conclusion
Recent law changes have made the Kiddie Tax a bigger threat to affluent families. However, with smart planning, you can still avoid much of the Kiddie Tax effects. Please call us if you want more information about family planning strategies for 2008 and beyond.
Very Truly Yours,
SOUKUP, BUSH & ASSOCIATES, P.C.
