Kiddie Tax and Your Tax Return

The new "kiddie" tax rule, which increases the number of years during which a child's investment income can be taxed at the parent's rate, is really nothing to brag about. The reason is because most custodial accounts, especially in the early years, are not large enough for annual earnings to activate the tax.

The new kiddie tax change, which was approved by congress, is good only until a child turns 18, as apposed to the old law where it was done away with on the child's 14th birthday. For 2006 and 2007, a child's investment income that exceeds $1,700 is taxed at the parent's rate. To earn $1,700 of income, the invested principal would have to be at least $21,250, assuming an 8 percent annual yield. The first $850.00 of a child's investment earnings will remain tax-free, whereas, the next $850.00 is taxed at the child's rate, which is 10% for interest income and 5% for qualified dividends, and long-term capital gains. The parent's rate can go as high as 35%.

The new rule could create a big problem for parents who had plans to give their children stocks or other appreciated assets, with the intention of shifting the tax on the gain to a lower tax bracket. Mind you it may still work, but the child will have to wait until he or she is 18 to sell the securities.

But there is good news for parents of children who are 18 and older. Beginning in 2008 long-term capital gains will become tax-free for those in the two lowest income-tax brackets, with taxable income under $33,000. If you give appreciated stocks to your children they'll pay no tax on the gain as long as they are 18 and over and sell the shares in 2008, 2009 or 2010. According to tax expert, Bill Fleming, that is a nice bonus if your children are the right age at the right time.

There is another option if you feel that your child's college fund will grow big enough to cause kiddie-tax problems later on. You can cash out the custodial account and transfer the money to a state-sponsored 529 college-savings plan, which will allow your savings to grow tax-deferred. If you use distributions for qualified college expenses, they won't be subject to federal taxes. However, the 529 plan will be the best choice over the custodial accounts, if you are just starting to save for your child's education.

A 529 plan should also be an attractive alternation because some states offer tax breaks to residents, even though contributions are not deductible on federal taxes. For example, in Connecticut, married couples can deduct 529 contributions up to $10,000 ($5,000 for individuals), no matter what their income is. With a 5% state income tax, that would save $500.00 in state taxes.

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