Kiddie Tax Extended to Children Under 18
by Julie Welch (Runtz)
The Tax Increase Prevention and Reconciliation Act recently signed into law included some benefits, such as extending the reduced capital gains tax rate of 15% through 2010 and reducing the Alternative Minimum Tax burden by increasing the exemption for ‘06.
However, to help offset the cost of the tax reduction provisions, the law retroactively increased the age of children subject to the “Kiddie Tax,” which taxes children’s unearned income of more than $1,700 at their parent’s tax rate—resulting in a higher tax.
Before 1986, parents shifted investments to children so that interest and dividend income from the investments would be reported on the children’s returns. Often, children paid little or no tax because they sheltered the investment income with their standard deduction and exemption deduction and/or paid tax at their low tax rates.
In 1986, Congress attacked this tax strategy in three ways. First, only one exemption deduction per person is allowed. If you claim your child as a dependent on your return, your child loses his or her personal exemption deduction.
Second, if you claim your child as a dependent, your child’s standard deduction—usually $5,150—decreases to the greater of $850 or the compensation income of the child plus $250. So if your child’s compensation income is $400, your child’s standard deduction is $850. If your child’s compensation income is $1,800, your child’s standard deduction is $2,050.
Third, beginning in 2006, if your child is under age 18 (previously age 14), any investment income over $1,700 may be taxed at your tax rate unless the child is married and files a joint return.
Including your child’s income on your return
If you have children under 18 who must pay tax, you can choose to include this income on your return if you meet the following requirements:
- The income must be only from interest and dividends (including mutual fund capital gain distributions),
- Your child’s interest and dividends must be more than $850 and less than $8,500, and
- Your child must not pay separate estimated tax payments or have any backup withholding.
Including your child’s income in your return may be a bad idea. By including your children’s income in your own return, you increase your adjusted gross income. As a result, your deductions could decrease.
- First, your deductions for medical expenses, casualty losses, and miscellaneous deductions are limited based on your AGI.
- Second, you may have to decrease your Individual Retirement Account deduction.
- Third, you may not be able to contribute to a Roth IRA.
- Fourth, your itemized deductions and exemption deductions could be phased out (reduced).
- Fifth, some of your credits, such as the dependent care credit and the child credit, could decrease.
Many parents include their children’s income in their returns to avoid the hassle or cost of filing federal and state returns for their children. Although this reasoning is understandable, you may pay more tax if you include your children’s income in your return.
Strategies to avoid the Kiddie Tax
You can use several strategies to avoid paying tax on your child’s investment income at your tax rates. First, you do not even need to file a return for your child if your child’s income is under $850.
Second, your child under age 18 can receive $1,700 of investment income in addition to compensation income before paying tax at your rate. For 2006, your depen-dent child’s standard deduction is the greater of $850 or your child’s compensation income plus $250 up to $5,150. In other words, compensation income can increase your child’s standard deduction and does not change the amount of investment income your child can receive before your tax rate applies to their income.
Third, when your child’s investment income reaches $1,700, consider investments that do not increase your child’s taxable income. Examples include:
- Tax-exempt municipal bonds,
- Growth stocks and mutual funds which pay no current dividends,
- Real property which appreciates in value, and
- Tax-deferred U.S. Savings bonds.
Fourth, split your child’s income with a trust. Trusts pay tax on income that is kept in the trust and not paid to your child. The first $2,050 of trust taxable income is taxed at a 15% tax rate.
Many parents shift income to their children so they can save money for the child’s college costs at a lower tax rate. However, as a result of the recent law change, until the child turns 18, the child may pay tax at the parent’s tax rate. You can avoid this higher rate by knowing how much income your child can receive before your tax rate applies and choosing investments that do not increase your child’s taxable income.
Julie Welch (Runtz) is director of tax services at Meara, King & Co. She can be reached by phone at 816.561.6868 or by email at julie@meara.com.