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January 7, 2007 - I've learned our family will be subject to the Kiddie Tax with a recent change in law. Can you explain the Kiddie Tax and the implication of this law change?

In May of 2006, Congress enacted a law change that significantly expands the reach of the Kiddie Tax. Previously, the Kiddie Tax imposed the parents' top tax rate on the investment income of a child under age 14. Effective now with the 2006 tax year, the law change will expand the reach of the Kiddie Tax to children who have not attained the age of 18 before the close of the tax year.

Fortunately, the Kiddie Tax only applies to unearned income such as interest, dividends, rents and capital gains. It does not apply to wages and self-employment income that arise from the personal services of the child.

There is a small exemption that continues to apply to the Kiddie Tax. For 2006, the first $850 of unearned income of a child under age 18 is tax-free, and the next $850 is taxed at the child's marginal rate, generally 10 percent. But to the extent the unearned income exceeds $1,700; the parents' higher income tax rate is applied to the unearned income.

For those families whose teenagers have accumulated some investments, the implications of this law change could lead to a surprising tax cost. For example, interest income in excess of $1,700 received by the child will be taxed at the parent's higher tax rate. If the child's unearned income consisted of dividends or long-term capital gains, the tax increase is less severe. Typically, the child is taxed at a special 5 percent rate on dividends and capital gains, whereas the parents are taxed at 15 percent. Accordingly, an extra 10 percent tax occurs on this type of unearned income of the child over $1,700.

In some cases, the implications of the Kiddie Tax could be significant enough to cause a repositioning of investments for a child under age 18. Rather than incur the parents' higher tax rate on investment earnings, it may make sense to shift the child's investments to growth equities that pay little or no dividends. Or consider tax-exempt municipal bonds or tax-sheltered savings vehicles such as IRAs, qualified tuition/Section 529 plans and the like. Also, be aware of the implications of the Kiddie Tax if you are considering recognizing capital gains on investments that the child has accumulated, you may want to hold off on the sale until the child is 18 to get the lower 5 percent capital gain rate, at least for about the first $30,000 of gain.

Another unfortunate aspect of this Kiddie Tax law change is the added tax return preparation hassle. If a child under age 18 has over $1,700 of investment income, that child's tax return needs to be carefully coordinated with the parents' return. Either the child's investment income is electively moved into the parent return for taxation, or alternatively a complicated schedule is added to the child's tax return that integrates both the parents' and child's income to arrive at the proper Kiddie Tax. Consequently, the child's return can no longer be done separately and filed early.

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