Kiddie Tax Loophole Soon to Disappear

Here's a piece courtesy of Marotta Asset Management on the kiddie tax loophole that is soon to expire.

Income-shifting is one of several tax planning tools families have used to lower their tax bill. Historically, parents could save a bundle by transferring highly appreciated investments to their children who are in lower tax brackets. However, this year, Congress has made income-shifting a dream of the past, trapping more kids in the dreaded "kiddie tax." Beginning January 1, 2008, children under 24 will owe taxes on unearned income at their parents' higher tax rates.

The "kiddie tax," or so it has been affectionately named, is a tax on children's unearned investment income or capital gains. Instead of taxing income and capital gains based on the child's tax bracket, the kiddie tax requires unearned income to be taxed at the parents' income and capital gains rates.

Before the expansion of the kiddie tax, parents turned to Uniform Transfer to Minors Accounts (UTMAs) or Uniform Gift to Minors Accounts (UGMAs) to move appreciated investments out of their estate. Once in the child's name, the assets were taxable at the child's - typically much lower - tax rates.

Shifting appreciated assets to a child could save a family 10% in capital gains taxes. Since most children earn little income, they usually fall into the lowest marginal tax brackets of 10% or 15%. Capital gains in these lowest two brackets are taxed at just 5%, compared to the typical 15% rate paid by many parents.

Savings could be even greater on short-term gains and investment income which are taxable at ordinary income tax rates. A child in the 10% bracket would pay 10% tax, instead of rates as high as 35% if mom and dad own the asset.

A once-in-a-lifetime kiddie tax loophole made intergenerational transfers even more appealing. In 2008, 2009, and 2010, capital gains rates are set to drop from 5% to 0% for individuals in 10% and 15% tax brackets. In other words, before the recent changes to the kiddie tax law, children 18 and over in the lowest two tax brackets could expect to pay no capital gains taxes in the next three years.

The new kiddie tax rule closes this loophole forever. If you were waiting for the days of 0% capital gains tax, you can kiss that dream good-bye.

Through 2005, the kiddie tax was limited to kids under 14. Last year, Congress cast the tax net wider, requiring children under age 18 to pay the kiddie tax. And this year, with the passage of the Small Business and Work Opportunity Tax Act of 2007, children under 19, or full-time students up to 24, will be subject to the kiddie tax. The good news is the new kiddie tax law doesn't take effect until January 1, 2008. If your child is between the ages of 18 to 23 this year you can still realize gains at your child's lower rate, if you act now.

After January 1st, children under 19, or full-time students under 24 will be stuck paying income and capital gains at their parents' tax rates. The kiddie tax applies as follows: No tax on the first $850 of earnings. Income between $851 and $1,700 is taxed at your child's tax rate. Any unearned income over $1,700 is taxable at the parents' marginal tax rate. However, children who provide for more than half of their own support will not be subject to the new law.

The expanded kiddie tax law now makes UGMA and UTMA a poor choice for college savings. Instead, 529 college savings accounts provide tax-free growth on contributions, allowing families to reduce their exposure to income and capital gains taxes. Qualified expenses such as college tuition, books, room and board can be withdrawn tax-free. And unlike UGMA and UTMA accounts, the college savings accounts are owned by the parent.

Comments

[Phil]

I'm quite annoyed about this since this was one of my vehicles for funding college. I currently have my first daughter in college this year, so our contribution towards her college bills for this year are coming from the transference of stock. Fortunately the stock has appreciated quite a bit since the transfer so we get some additional benefit. I'll be running a couple of different scenarios for next tax year with my CFP. I wonder if I were not to claim her as a dependent next year and still give her the stock if she then pays cap gains at her independent "unmarried single" rate.

I was hoping to kill two birds with one stone by going this route - finance college and rebalance my portfolio by giving away my pure stocks that have done well.

I seem to remember the last time congress raised the age from 14 to 18 (I think it was before last year) they made it retroactive to that current tax year which messed up a lot of people who had already transferred and sold the investments. Fortunately, this time they passed the law effective in the next tax year so I at least get to execute my strategy cleanly for one year.

[Kevin]

Phil - your daughter should pay at her rates assuming she is over 18 and not a dependent. Of course, next year you are in trouble, unless she provides half her support with earned income (wages).