The “Kiddie Tax” Grows Up Fast

While Congress has provided many favorable tax breaks to individuals in recent years, the “kiddie” tax has been expanded, subjecting some parents of children with investment income to a sudden tax increase. For many families, this sudden change affects their tax-efficient investing strategies, particularly those developed to help fund a college education. While the reform does not affect the taxation of 529 plans or Coverdell Education Savings Accounts (ESAs), it does affect custodial accounts and investment holdings that generate taxable income.

The Tax Impact

In 2012, the kiddie tax kicks in when investment income exceeds $1,900 for children under age 19 (or under age 24 for full-time students). They do not pay tax on the first $950 of investment income, and they pay tax at their own rate on the next $950. Any unearned income above $1,900 is taxed at the parent’s rate. For long-term capital gains, the top rate is 15%, while the top marginal income tax rate is 35%. Bear in mind that the kiddie tax only applies to a child’s unearned income; wages from employment are exempt.

For illustrative purposes, let’s suppose your 16-year-old daughter has $5,000 of interest income. Under current rules, she pays no tax on the first $950 and then 10% on the next $950. The remaining $3,100 is taxed at your rate, and let’s assume it’s 35%. The tax on her income would total $1,085. Under the old rules, her tax would have been $405.

In the past, to take advantage of their children’s lower tax brackets, many parents shifted appreciated stock to their kids. The children would then sell the assets, oftentimes to pay for college expenses, and pay tax at their own, likely lower, rates.

With the kiddie tax’s bump up in age, however, these asset-shifting plans now have different tax consequences. Rather than owing zero tax on long-term gains for their college-bound kids, unsuspecting families may now owe 15%.

Alternate Strategies

If changes in the kiddie tax negatively impact your education strategies, consider your other tax-favored options, such as 529 plans and ESAs. 529 college savings plans are state-sponsored investment accounts that offer tax-deferred earnings and tax-free withdrawals for qualified higher education expenses. Eliminating some of the uncertainty surrounding these plans, Congress made permanent the favorable tax benefits for 529 plans that were set to expire in 2010.

ESAs also offer tax-deferred earnings and tax-free withdrawals, and funds may be used to fund secondary-school expenses, as well as college expenses. Annual contributions are limited to $2,000, and income limits apply.

To keep a child’s investment income low, consider growth stocks that pay little in dividends. The tax liability occurs if and when the stocks are sold for a gain. Also consider tax-efficient and low-turnover mutual funds. Buying and holding an investment until a child reaches age 19 can help you mitigate the implications of the new rules.

Financial Aid Considerations

When it comes to financial aid, there are definitely advantages to keeping money earmarked for education out of your child’s name. Colleges generally expect 35% of a student’s assets to be dedicated to education, whereas the expectation for parents is lower—only 6% of your assets are considered in the funding formula for aid. The less savings children have in their own name, the more aid they may receive, depending on the cost of attendance and your family’s overall financial situation.

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