TIP: Watch Out For The “Kiddie Tax” Trap

Tip of the Month

July 2007

TIP: Watch Out For The “Kiddie Tax” Trap

Congress has voted to raise the age limit for collecting what has become known as the “kiddie tax” to widen its reach and boost tax income. This move means that investment income accruing to a child could mean higher-than-expected taxes for their families when the child’s investments are sold. These new tax provisions primarily target custodial accounts, often used as a tax strategy to allow family members in higher tax brackets to give income-generating assets to family members in lower tax brackets. Using this idea, grandparents or parents have opened custodial accounts and purchased assets in the names of the children—frequently with the idea that the children would liquidate the accounts to fund college expenses paying relatively low long-term capital gains taxes (5 percent for people in the 10 or 15 percent tax brackets—though current laws impose no tax on people in these brackets from 2008-2010). The applicable provisions of the new tax law do not take effect until January 1 2008, giving families the chance to try to review their options with their tax advisors to try to limit tax liabilities before year-end.

These revisions to the tax code were overshadowed by other tax and funding issues when they were approved. The changes were made in part to cover $5 billion in new tax breaks for small businesses and were written into the Small Business and Work Opportunity Tax Act, which, in turn, was part of further legislation involving military and disaster recovery funding.

Here’s an overview of the implications of the new tax law provisions:

If a child’s investment income (interest, dividends and capital gains.) from custodial accounts exceeds $1,700, and the child falls into “kiddie tax” age bracket, this income will be taxed at the parents’ tax rate.

The first $1,700 is not taxed at the parents’ tax rate.

Last year, Congress raised the age for the “kiddie tax” to under 18 from its previous ceiling of under 14. This latest adjustment widens the net, raising the age to under 18, or under 24 for students who do not earn sufficient funds to provide more than half their own support.

The new tax rules do not affect Section 529 college savings plans. Earnings on these accounts remain tax-free when distributed for approved educational purposes.

Section 529 plans have only existed for a decade or so, and so many families may have custodial accounts established for their older children, which could be affected by these revisions to tax laws.

Before making any moves, it is advisable to consult with a tax professional and review the various options available to you and your family. There are many issues to consider, including the ages of various children, other important strategic planning matters, and the family’s overall estate planning goals.

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.