Expanded Kiddie Tax Impacts Savings Strategy

You take advantage of every break you can to save for college. But what do you do when tax-rule changes suddenly throw you a curve ball? For families concerned about the tab of higher education, the curve-ball question is now more than hypothetical.

Teenagers with savings have just been handed a much bigger tax bill on all manner of investment income: dividends, interest and capital gains. The change comes because Congress just expanded the so-called kiddie tax, which requires youngsters to pay taxes at their parents' higher income-tax rates.

For some families that's a significant change. New rules closed a popular loophole that's been used to shelter savings frequently earmarked for a child's education, says Mark Luscombe, principal tax analyst at CCH, a tax information and software publishing firm.

"(Under the old rules), you could basically put money in a kid's name and it would be taxed at lower rates and you could spend it on college," says Luscombe. "Now that doesn't work."

How the 'kiddie tax' works

With the so-called "kiddie tax," children owe nothing on the first $850 (in 2006) of investment income earned. The second $850 is taxed at their rate. With the exception of Dakota Fanning and other pre-pubescent millionaires, that's usually a low 5 percent on dividends and long-term capital gains, and no more than 10 percent or 15 percent on short-term gains and interest. Investment income exceeding $1,700 is taxed at parents' tax rates -- 15 percent for dividends and long-term gains and up to 35 percent on interest and short-term gains.

Before the Tax Increase Prevention and Reconciliation Act went into effect in mid-May, kiddie taxes would have expired when teens turned 14, at which point they paid their own low rate on all investment income. Under the new law, all kids up to age 18 are subject to the system.

In fact, the expansion is retroactive to Jan. 1, 2006. Government accountants estimate it will generate $2.1 billion in revenues over the next decade.

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Shifting strategies

While there are still plenty of smart ways to save, individuals now need to be mindful of pitfalls and maximize other savings options. What to do and what to avoid:

1. Keep education money out of your kid's name.
It's not just their parents' tax rate that children have to worry about. "You really don't want assets in a student's name if you need financial aid," says Sandy Baum, a senior policy analyst with the College Board.

As it turns out, teens who've amassed hefty savings and investments are less likely to qualify for scholarships than kids whose parents retain those same assets. That's because in terms of financial aid, colleges use a funding formula that requires students to spend 35 percent of their savings on education. (The new Deficit Reduction Act calls for reducing the rate to 20 percent, but not until July 2007.) Parents have to devote less -- no more than roughly 6 percent of assets -- toward school costs. In other words, dollar for dollar, you get more financial help if parents stash education funds in their own names.

2. Fund a 529.
Earnings in these plans grow tax free, and monies can be withdrawn without tax levies, too, as long as they are used for legitimate college expenses such as tuition, room, board and books. Moreover, students applying for financial aid are less likely to be penalized if their education savings are held in a 529 plan, since colleges include the plans among parents' holdings. 

"From a financial aid standpoint, (529s) have become less and less damaging. Parents should be more encouraged about using 529s," says KC Dempster at College Money, a New Jersey college financial planning firm.

3. Consider a Coverdell.
You may stash up to $2,000, annually, per child in these plans, and earnings can grow and be withdrawn tax-free. If that doesn't sound like much, consider this: Families who begin saving $2,000 a year in a Coverdell for a newborn will have about $75,000 by the time he or she is an 18-year-old college freshman, assuming an annualized return of 8 percent.

Plus, unlike 529s, Coverdells can be used for earlier education expenses. "Money in a Coverdell can be used for kindergarten to high school education expenses, not just college. It's a great deal," says Dee Lee, a certified financial planner and author of "Women and Money."

4. Hire your kid.
Want to shift savings to your children? Give them a job. They'll pay very little income tax and, as long as they're under 18 and not working at a "principal" job (that's IRS parlance for a full-time career), they won't owe Social Security taxes, either. Another benefit: As a business owner, you can deduct their wages, too. Keep in mind that the IRS takes a dim view of inflated salaries, so pay a realistic amount. And don't try to pass your toddler off as a bookkeeper or you might trigger an audit.

"You can't hire your kid at $40 an hour if they empty trash cans. That's unreasonable. But if a kid is computer-literate, they can help with a variety of things," says Phil Johnson, a certified financial planner in Clifton Park, N.Y.

5. Have grandparents pay tuition.
As long as the check is made out to the school directly, grandparents (or anyone, for that matter) won't owe gift tax on money they contribute toward a student's education.

6. Fund your own retirement.
Planners agree, that when it comes to priorities, retirement comes first. After all, there's no retirement scholarship for old age.

Also keep in mind that you can elect to use retirement funds toward college expenses if you feel you must. For example, you won't owe the usual 10-percent penalty if you tap your IRA for college expenses before you hit the required minimum age of 59½, for penalty-free withdrawals. Nor will you owe taxes or penalties if you withdraw Roth contributions early. Meanwhile, some employer-sponsored retirement funds, such as 401(k) or 403(b) plans, let workers borrow against them.

7. Keep an eye on Washington.
Tax perks for 529 savings plans are scheduled to expire in 2010. At that point, students would owe their own tax rate on earnings, so they'd still be a relatively good deal. To date, individuals have amassed a whopping $89 billion for future college costs in more than 8.5 million 529 plans, according to the College Savings Plan Network.

Politicians are well aware of the plans' popularity, and at least 70 senators have signed legislation co-sponsored by Sens. Charles Grassley, R-Iowa, and Max Baucus, D-Mont., to make 529s permanently tax free. Similar changes are being considered in the House of Representatives.

Meanwhile, some groups are not thrilled that teenagers are now subject to higher taxes. Americans for Tax Reform, which lobbies for lower taxes, has started campaigning against the expanded kiddie tax, says its president, Grover Norquist.

"We're supportive of a rollback," says Norquist. "This is something that families are concerned about."

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