Surprised by the Kiddie Tax?
There are Ways to Avoid It!
Were you caught by surprise when you found out that your almost-adult child was subject to the kiddie tax? You were not alone. Under legislation passed in early 2006, Congress revised the kiddie tax rules to apply to children through the age of 17 (previously 13).
To prevent parents from placing investments in their children’s names to take advantage of the child’s lower tax rate, Congress several years back created what is referred to as the “kiddie tax.” Under the kiddie tax, a child’s investment income in excess of an annual floor amount ($1,700 for 2007) is taxed at the parent’s tax rate rather than the child’s. These rules do not apply to married children who file a joint return with their spouse.
Depending upon your circumstances, this can be either a tax return preparation nuisance or a penalty tax – or maybe both. Many insightful parents seek tax-advantaged ways to put money aside for their children’s education, first home, etc. They should not be deterred by the kiddie tax, as there are legal ways to avoid it. This generally is accomplished by making investments that produce tax-free income or that defers income until the year that the child reaches age 18 or older. If, at that time, the child is in school with little or no other income, the deferred income could be realized with little or no income tax.
The following are examples of investments that either defer income or generate tax-free income. However, you also must consider that some of these might have a lower rate of return than a taxable investment:
U.S. Savings Bonds: Interest can be deferred until the bonds are cashed.
Municipal Bonds: Generally produce tax-free interest income for federal taxes. Most states with a state income tax also permit tax-free treatment of interest from bonds of that state or local governments within that state.
Growth Stocks: Stocks that focus more on capital appreciation than current income. The child could wait to sell them until after attaining age 18 and possibly be in school with no other income. Another technique is for the parents to gift appreciated stock to their children, thereby shifting gain to the children when the stock is sold. Thus, each parent could gift appreciated property, as an example, stock, valued not exceeding the annual gift tax exclusion amount ($12,000 for 2007), to each child without current tax consequences. Later, when the child sells the appreciated property, the child would pay the tax on the parent’s appreciation.
Unimproved Real Estate: That provides appreciation without current income.
If the family has a
business, that family business could employ the child. The child’s earned income is not subject to the kiddie
tax rules and will generate a deduction for the family business (assuming that the wages are reasonable for the
work actually performed). The child’s earned income can offset the standard deduction for a dependent, and the
excess income will be taxed at the child’s rate (not the parent’s). In addition, the child also would qualify
for an IRA, which provides additional income shelter.
E Thomas Associates Inc. is a registered investment advisor in Kentucky.
Dave Smith & Tony King are Registered Representatives of and securities are offered through Dalton Strategic Investment Services, Inc., member FINRA & SIPC. 6408 River's Edge Rd, Greenville, OH 45331
.