Reporting a Child's Income on Child's Return

The unearned income (interest, dividends, investments, etc.) of a child under the age of 18 will be taxed at the parents' highest marginal tax rate, unless the parents make a special election to include the child's income on the parents' return. If the election isn't made, and the child files a separate return, no personal exemption is allowed if the child could have been claimed as a dependent on his or her parents' return.

Warning In 2007, the age limit for application of this special rule (the "kiddie tax") was raised to children under the age of 19, and to full-time students under the age of 24 whose earnings amount to less than one-half of his or her support. The change is effective only for tax years beginning after May 25, 2007. This means that, for calendar-year taxpayers, the new age limits take effect in the 2008 tax year. Fiscal-year taxpayers whose tax year began after that date are subject to the new rules.

However, the child can use up to $850 for 2007 ($900 for 2008) of his or her standard deduction to offset unearned income. Thus, only unearned income in excess of $1,700 for 2007 is taxed at the parents' top marginal rate. These amounts are indexed annually for inflation.

In computing the parents' top marginal rate, all unearned income of children under age 18 in 2007 in excess of $1,700 is added to the parents' otherwise taxable income. The result is that, in some circumstances, the unearned income of a child under age 18 may be taxed at the 35 percent rate, while the parents' top rate would otherwise (based on their actual income) be lower.

The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) raised the kiddie tax age threshold from 14 to 18. This provision became effective for the entire 2006 tax year. The change is part of the $20 billion in revenue raisers that help offset the $90 billion in newly enacted tax breaks.

This change seriously impacts some existing tax planning opportunities. Parents who had planned to sell a child's college stock portfolio after age 13 and before entering college have no opportunity now to accelerate that planning technique if the child is over 13. If the family was planning to postpone a sale until 2008, when the top rate for capital gains would be zero, that's a loss of 15 percentage points on the tax otherwise not due on the sale of stock or other portfolio assets.

Save Money These tax rules can be an unexpected burden for many families saving for college. However, the following gift-giving strategies can help reduce or even eliminate the kiddie tax and cut the overall family tax bill: Buy Series EE bonds for the child and have the child elect to defer tax on the interest as it accrues. Invest the child's money in securities with low yields but strong appreciation potential. If the securities are retained until age 18 or later, appreciation during the child's younger years escapes the kiddie tax. Invest in raw land with appreciation potential. From the tax viewpoint, the land should be held until the child reaches age 18 or later. Buy cash-value life insurance. Inside build-up from the policy will accumulate tax-free. If the child is a beneficiary of a trust, coordinate trust income with income from outside of the trust. Although this is a less attractive option, one can still accumulate trust income up to the amount taxed to the trust at the 15 percent rate ($2,200 for tax years beginning in 2007). Place UGMA and Uniform Transfers to Minors Act (UTMA) funds in tax-exempt bonds until the child reaches age 18. Tax-exempt zero coupon bonds may be a particularly good way to avoid the kiddie tax and build a college fund. Another approach is to buy stripped municipal bonds. Buy market discount bonds for the child, keeping the current yield below $1,700 (for 2007) so that the kiddie tax will not apply. When the bond is redeemed (or sold) after the child reaches age 18, the built-in discount will be taxed at the child's rates. Set up a gift-giving program that keeps the child's unearned income below the $1,700 threshold until he or she reaches age 18. For example, a cash gift to a 10-year-old child of $9,000, earning interest at eight percent, could grow over $3,000 by the time the child reaches age 18, and each year's interest will not exceed $1,300. Thereafter, the parent can set aside larger amounts for the child and continue to achieve effective family income-splitting. Employ the child in the family business or in the performance of chores supporting the payment of earned income. The income can be sheltered by the standard deduction. Even a young child can perform compensable services.

Additional changes. The Small Business and Work Opportunity Tax Act of 2007 extends the reach of the kiddie tax by raising the age limit to include all children under age 19 (previously under age 18) and students under age 24. Both changes are effective for tax years beginning after May 25, 2007.

The effective date for the new kiddie tax provision brings with it some good news and some bad news. For calendar-year taxpayers, the higher age limit starts in 2008. The last hike in the kiddie tax, from age 14 through age 17, was made retroactive to the beginning of 2006. This time, the change is not retroactive and, for most taxpayers, does not take effect until next year. Parents have the option to sell quickly in 2007, while the old rule is still in effect.

However, because this provision is effective for tax years beginning after May 25, 2007, there is also some bad news. It is not until 2008 that capital gain for those in the 15 percent or lower tax brackets fall to zero rather than 10 percent. That zero no-tax rate remains through 2010. Many lawmakers earlier this year called for preventing dependents under age 24 from using the zero percent rate. The new law covers this loophole and more by expanding the kiddie tax.

The actual computation of the kiddie tax remains the same. The net unearned income of the child (for 2007, generally unearned income over $1,700) is taxed at the parents' marginal tax rates, if the rates are higher than the child's tax rates. Only last year, TIPRA raised the reach of the kiddie tax from under age 14 to under age 18.

The main downside of the new kiddie tax provision is that college age students will no longer be able to sell off their appreciated investment accounts set up by the parents to cover current tuition. At a minimum, taking out student loans with interest until the year the student turns 24 will be necessary now to carry forward such a plan. However, the maximum tax of capital gains imposed on any stock sales might rise from 15 to 20 percent after 2010, adding another price tag to postponing income recognition.