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Kiddie Tax Rules for 2006 and 2007
The children’s piggy bank diet began in 1987 when the Internal Revenue Service (IRS) began subjecting the unearned savings of children under age 14 to their parents’ tax rate. Now, with a 2006 act of Congress, the pig is going to weigh even less. Kiddie tax, as it is commonly called, will now be imposed on children’s nonwage earnings until the child reaches 18 years of age.
Taxing children’s unearned income began in 1987 to stop parents from sheltering savings from taxes by putting funds into children’s lower-taxed accounts. The piggy bank has taken longer to fatten up ever since. By subjecting an even larger group of children to tax beginning in 2006, the IRS estimates that it will collect $2 billion over the next ten years.
How does kiddie tax work?
First, kiddie tax is only assessed on unearned income such as taxable interest, dividends, capital gains, etc. For children under the age of 18, the first $850 is tax-free. The next $850 is taxed at no more than ten percent; then it gets a little more complicated. For 2006, if the child has an income less than $30,650, capital gains and qualified dividends only, can be taxed at the lower capital gain rate of five percent. This does not include interest, which is considered unearned income. Unearned income over $1,700 is taxed at the parents’ income tax rate. If the taxpayer has more than one child under age 18, additional computations are required.
Special rules apply for 2008-2010; the tax rate will be zero for those who have parents in the 10-to-15-percent income tax bracket.
How do the new rules change the savings strategy?
The new kiddie tax rules also change how you can help your children, and grandchildren, save for their future. When it comes to children’s savings and college, the advantages of having children save in their own accounts or custodial accounts have become less appealing. Giving appreciated stock to teens to sell for college expenses is less advantageous now also, unless the child can wait to sell them until they are age 18. Likewise, using investments for children’s savings are less desirable because investments bear interest and are thus subject to taxation. Saving will require a little more strategizing, but it’s do-able and if one looks hard for a silver lining, it is that if the child has less in assets, he or she is more likely to qualify for financial aid when entering college.
Changes in the kiddie tax also affect trusts. The trustees of all trusts having beneficiaries older than 14 and under 18 years of age need to review their investment strategies immediately. If unearned income of the trust is accumulated—that is, not distributed currently—the income may be subject to the compressed income tax rates for trusts. If the income is distributed free of the trust, then it may be necessary to hold it in a custodial account.
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