Tax Article - Kiddie Tax: It's All About the Age

Congress recently passed a new law that will expand the reach of the "kiddie tax" and prevent many wealthy parents from taking advantage of a popular tax-saving strategy. The tax-saving strategy involves parents or grandparents transferring or gifting appreciated shares of stocks and mutual funds to children or grandchildren in lower tax brackets. In doing so, parents in higher tax brackets avoid paying tax at the maximum long-term capital gain tax rate (15%) upon sale. Instead, the children in the 10% or 15% tax brackets sell the investments and pay tax at their lower long-term capital gain rate, currently set at 5%. This strategy had been gaining considerable attention recently because of the fact that the current 5% tax rate on long-term capital gains is scheduled to be reduced to 0% in 2008. Conversely, the 15% long-term capital gain tax rate that higher income tax payers are subject to will remain unchanged.

The kiddie tax rules have long been in place to deter taxpayers in higher tax brackets from reducing their family's tax bill by transferring significant amounts of wealth to their children or grandchildren. The rules require children with significant amounts of investment income to pay tax on a portion of it at their parents' higher tax rates. Prior to 2006, the kiddie tax rules only applied to children under the age of 14. Congress modified the rules such that for 2006 and 2007, children under the age of 18 must pay income tax at their parents’ rates on investment income in excess of $1,700.

Under the new law, beginning in 2008, the age limit has increased to include 18-year old children as well as full-time students until they reach the age of 24. The law will not apply to children who work and earn a salary that exceeds one-half of their support.

Taxpayers who planned to take advantage of the scheduled 0% capital gain tax rate in 2008 by transferring to an individual under the age of 24 will now have to reevaluate their strategy. However, since the new law doesn’t go into effect until 2008, there is still opportunity to take advantage of the reduced 5% rate. If you transferred or plan to transfer appreciated securities to a child that will be 18 years or older on 12/31/07, you may still sell them before the end of 2007 and take advantage of the lower tax rate. Keep in mind that there are gift tax implications that should be taken into account should you elect to make a gift. You should consult your tax advisor for more information specific to your situation.

If the strategy above was designed in part to use assets to pay college tuition expenses, you may want to instead consider a 529 college-savings plan. The growth on these investments are tax-deferred and therefore not subject to the kiddie tax. Municipal bonds may also be a consideration as earnings are not subject to taxation. 

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