Congress Closes Kiddie Tax Loophole

Sometimes the best-laid plans go awry – and this time, you can blame Congress. If part of your tax planning included giving appreciated stocks, mutual funds or other assets to your teen or college student so he or she could sell them tax-free next year, it’s time for plan B.

Some wealthy families were eagerly awaiting the effective date of a new law that wipes out capital-gains taxes for those in the two lowest income-tax brackets (often children and the elderly) in 2008, 2009 and 2010. But now Congress has effectively dismantled that income-shifting strategy with its latest expansion of the “kiddie tax” — the second change in just over a year. However, if you have kids who are 18 to 23 years old by the end of the year, you still have time to act before the latest change kicks in on January 1.

Who’s a kid?
Currently, the law that taxes certain investment income of children at their parents’ higher rate applies to kids under 18. (Before 2006, it applied to children under 14.) In 2007, the first $850 of a child’s investment income is tax free and the next $850 is taxed at his or her own rate. But any unearned income in excess of $1,700 in 2007 is taxed at the parents’ presumably higher tax rate. (These limits are adjusted for inflation and will be slightly higher next year.)

Starting in 2008, the kiddie tax will be expanded to include dependents under 19 and dependent full-time students under 24. Children who provide more than half of their own support are not affected by the kiddie-tax change.

What does that mean for you? If your children are 18 through 23 by the end of the year, they can still take advantage of the 5% rate on long-term capital gains that’s available to taxpayers in the two lowest brackets, says Bob Scharin, senior tax analyst for Thomson Tax & Accounting. Higher-income taxpayers pay a maximum capital-gains tax of 15% on both qualified dividends and profits on investments that are held longer than one year. Interest income, and profits on short-term investments held less than one year, are taxed at ordinary income-tax rates ranging from 10% to 35%.

Savor the sweet spot
Mitchell Graham falls into the kiddie-tax sweet spot. His parents, Terri and Jeff, who live in Deerfield, Ill., have been saving for Mitchell’s college expenses in a variety of ways, using a custodial account, a 529 college-savings plan and their own assets. Because Mitchell turns 18 this summer, he is exempt from the current kiddie tax. But he’ll be covered by the new, expanded version next year. So if he sells assets in his account by December 31, he’ll benefit from the lowest tax rates to help pay his tuition when he enters Carroll College in Waukesha, Wis., as a freshman this fall.

You might also consider giving appreciated assets to children 18 or older to sell before the end of the year, either to pay for college or to minimize your family’s tax bill. An individual can give each recipient up to $12,000 this year without triggering the gift tax. (Married couples can jointly give up to $24,000 per recipient.)

As an example, let’s say you and your spouse gave your child $24,000 worth of appreciated stock, of which $12,000 represented profit when sold. Shifting from your 15% capital-gains rate to your child’s 5% rate would save $1,200 in taxes.

The latest change in the kiddie-tax rules makes saving for education expenses through a 529 plan more attractive than ever, says Scharin. As long as the money is used for qualified college expenses, withdrawals from 529 plans are tax-free and avoid the kiddie-tax issue altogether.

Source: Mary Beth Franklin. Mary Beth Franklin is a senior editor of Kiplinger’s Personal Financ magazine. She covers retirement planning, tax planning, Social Security issues and long-term-care insurance. Previously, she was co-editor of Kiplinger’s Retirement Report.