I’ve been noticing a lot of confusion on the kiddie tax rules lately so figured it was time to break it down. Too many parents are deciding not to put a token amount of money in their kids’ name in fear of the “kiddie tax” when in reality this tax should only hit you if you are transferring significant assets to your children. At the basic level, the “kiddie tax rules” are a series of tax laws that prevent wealthy taxpayers from shifting investment’s to their kids’ names in order to avoid the higher tax rates of their parents.
There have been some recent law changes to the kiddie tax rules. In fact, they have been simplified a bit. The kiddie tax will only affect the unearned income of kids under 18, and only the amount above a certain threshold. Unearned income would pretty much be dividends, interest, capital gains, or other income generated from investments, as opposed to earned wages.
The threshold for the kiddie tax in 2007 is $1,700. What this means, is the first $1,700 of unearned (or investment income) that your child earns in 2007 will be subject to tax at the child’s low tax rate, and everything above that amount will be taxed at the parents’ generally higher tax rate. In fact, a child under 18 does get a standard deduction to offset unearned income. The amount is $850. So the first $850 of unearned income is completely tax-free and the following $850 is taxed at a rate of 10%. (This rate is 5% for certain dividends and capital gains). So you can see for the first $1,700 of investment income every year, the low tax rates can be quite lucrative. Also, you can shift growth stocks and growth funds to your child, which pay little in dividends and capital gains, and avoid much of the kiddie tax, if they hold the same stocks and funds into adulthood.
In addition, to make it easier on you, the new kiddie tax rules allow you to report your child’s income on your own tax return if their income is limited to interest, dividends, and mutual fund capital gain distributions, all amounting to less than $8,500. So if you do take on a buy and hold strategy with your children’s money, the odds are you can simply report the amounts with your own tax return, which omits the hassle in the past of filing separate tax returns for each of your children. You simply report these amounts on a new income tax form – Form 8814 – one for each child. However, if your child(ren) do have capital gains or losses from the sale of stocks or funds, they will have to file separate tax returns.
Of course, most parents are socking away money for college for their kids, and vehicles like 529 plans can shelter the resulting investment income entirely from taxes until the money is withdrawn. However, if you had considered saving money for your children in their own name, outside of college savings, and been scared away by the kiddie tax, you may want to reconsider. Particularly in the early years, it isn’t too hard to shelter the initial investments in your children’s name from income taxes entirely.
As the money grows, you may want to be careful about selling stocks and realizing gains, but these stock sales are given preferential tax treatment even at parent’s level and generally do not generate much tax with today’s tax rules. Of course, the kicker is that the tax law is ever-changing so it is hard to plan too far into the future based on today’s tax code.
As the tax law stands for 2007 through 2010, investment gains will be treated very favorably, but in 2011 will revert to older rules, or less favorable tax treatment. All things to keep in mind. But for the most part, if you want to teach your kids about investing and give them token amounts to invest on their own, or set aside small cash gifts and portions of allowances in their name, you can do so without too much fear of the dreaded kiddie tax.