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Tax Changes for Kids

One of the seemingly overlooked provisions of the new tax legislation has to do with the new rules relative to the "kiddie tax."

Under the old rules, the law allowed children under the age of 14 to receive as much as $800 in tax-free investment income. The child didn't have to pay taxes on interest, dividends, or capital gains (either short- or long-term) up to this amount. Additionally, the child would have to pay taxes on the next $800, but at a lower tax rate than his or her parents. Once his or her investment income exceeded $1,600, the child was required to pay taxes at his or her parents' tax rate.

Before the recent changes in the kiddie tax rules, age 14 was the magic number. If the child was under age 14, you had to be careful of the kiddie tax rules if you were trying to "shift" income from higher-bracket taxpayers to kids. You generally didn't want to allow substantial gains or other investment income to be reported under the child's income until after they turned age 14 and the "kiddie tax" rules were no longer in play.

But this new legislation has made it more difficult for parents to shield higher taxes by passing investment income to the kids. For the current 2006 tax year, the "kiddie tax" age has been increased to 18. Now, until the child turns age 18, he or she may be required to pay taxes on his or her investment income at the higher "parents" rate.

For 2006, the first $850 on investment income remains untaxed, and the next $850 is taxed at the kids' rate. But more than $1,700 in investment income for a child under age 18 will trigger any tax to be paid at the higher parents' rate. The government estimates that the change in the kiddie tax provisions will generate $2.1 billion in taxes over the next 10 years, primarily from higher-income families.

This could be a very big deal for many of you trying to find a tax-advantaged method for helping your child fund his or her college savings, or simply wanting to pass investment income to a child in order to reduce overall taxes while retaining wealth in the family. Many clients of mine, whom you might not consider "higher-income," have used this technique in the past to legally reduce their family's tax liability by many thousands of dollars. That extra four-year wait (from age 14 to age 18) will have a tremendous impact.

To give you an example, consider Jack and Jill and their daughter Hilda, age 15. Jack and Jill are normally in the 25% bracket, whereas Hilda has virtually no other income. Jack and Jill want to gift some stock to Hilda to start her college savings program. They originally bought the stock for $1,000, and it is now worth $10,000. If Jack and Jill sell the shares, they will have a tax liability of about $1,350 on the gain. Instead, they decide to gift the shares to Hilda, who will then sell the shares and pay taxes at her lower rate.

Under the old rules, Hilda could sell the shares and pay only $410 in taxes. That's a "family" tax savings of $940, or a tax savings of about 70%. But under the new rules, Hilda would be subject to the "kiddie tax" (since she is not yet age 18). Her tax liability on this gain would amount to about $930, generating a family tax savings of only about $420 on the transaction. Taken over a four-year period (the difference between ages 14 to 18), Jack, Jill, and Hilda will pay roughly $2,080 in taxes they could have avoided with the old rules.

Make sure that you're aware of the new "kiddie tax" rules (effective now) before you plan any income-shifting gambits. More details can be found in IRS Publication 929; it currently reflects the old 2005 rules, but it will hopefully be updated soon with the new information. Keep checking back to get the latest facts.

When he's not dealing with tax issues, Fool contributorRoy Lewisis a motivational speaker who lives in a trailer down by the river. He understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.


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