"Kiddie Tax" Age Jumps to 17 Increasing the Tax Burden of Many Families Trying to Save for a Child's College Education

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As part of the Tax Increase Prevention and Reconciliation Act signed into law on May 17th, the "Kiddie Tax" age was increased from 13 to 17, retroactive to January 1, 2006. Many parents trying to save for a child's college education may find their tax burden increase because of this tax law change.

The Kiddie Tax, introduced as part of the massive Tax Reform Act of 1986, celebrates its twentieth birthday by becoming even broader. Prior to 2006, any unearned income above a certain threshold earned by a child under the age of 14 was taxed at the parent's tax rate. Thanks to the Tax Increase Prevention and Reconciliation Act of 2006, the Kiddie Tax now applies to children 17 or younger who earn more than $1,700 (in 2006) in interest, dividends, capital gains, and other non-wage income.

"Understanding how children are taxed is very important when determining how to best save money for their college education," explains Andrew Schwartz CPA, founder of FindAGoodCPA.com, a site where taxpayers can locate a CPA in their state who specializes in their specific tax issues.

For 2006, the first $850 of net investment income earned by a child isn't taxed, and the next $850 is taxed at a rate of either 5% or 10%, depending on the type of income earned. Any additional income is taxed based on the child's age as follows:

Children under the age of 18: A child's net investment income earned during the year that exceeds the $1,700 threshold (in 2006) is taxed at the parent's marginal tax rate.

Children over the age of 17: A child's income is taxed using the same tables that apply to single adults. For 2006, the first $7,550 of net taxable income is taxed at 10%, and then the next $23,100 is taxed at 15%. As with all taxpayers, corporate dividends and long-term capital gains are taxed at a lower rate.

Now that the Kiddie Tax applies to children through age 17, it makes even more sense for parents to save for a child's college education either in their own name or within a 529 Plan or Coverdell Education Savings Account (ESA). Previously, when the Kiddie Tax only affected children 13 and under, parents had three or four years prior to their child's high school graduation to liquidate investments held in their name in anticipation of paying for college while still taking full advantage of the lower tax rates.

There are other variables to factor in as well. Investments made in a child's name tend to reduce the amount of financial aid available to pay for college. Plus, if a child receives a full scholarship or decides not to go to college, any money saved in that child's name becomes his or her property upon reaching the applicable age of majority in their home state. And don't forget that the Pension Protection Act of 2006 made tax-free distributions from 529 plans permanent.

Reporting the Kiddie Tax
For 2006, if a child is under the age of 18 as of December 31st, and earns more than $850 of interest, dividends, capital gains and other unearned income, parents need to choose between the following two options when reporting that income to the IRS:

Form 8814: This form is used by parents when electing to include a child's income on their tax return instead of preparing a separate income tax return for that child.

Form 8615: This form is used to calculate the Kiddie Tax when preparing a separate tax return for the child.

This year, a parent can only report a child's income on their own tax return if the child's income is comprised of just interest, dividends, and capital gains distributions, and doesn't exceed $8,500.

"For the most part, the taxes owed on your child's income will be similar whether you include that income on your tax return or prepare separate tax returns for each of your kids. One exception applies if your adjusted gross income exceeds $150k, since reporting additional income on your tax return might cause more of your itemized deductions and personal exemptions to phase out - possibly increasing the taxes you'll end up paying on your child's income," says Schwartz.

It's A Balancing Act
Funding a child's college education continues to get increasingly more complicated. As the tax rules continue to evolve, and with the government unlikely to increase funding for college education any time soon, saving for college has become a balancing act between tuition projections in excess of a quarter of a million dollars, an increasing array of confusing tax breaks for parents and students, and diminishing financial aid opportunities.

About Andrew D. Schwartz CPA
Andrew D. Schwartz, CPA is the editor and founder of http://www.FindAGoodCPA.com, a site where taxpayers can interact with CPAs who specialize in a variety of niches such as healthcare, real estate professionals, and lawyers. Schwartz has provided tax and basic financial planning advice in interviews with various media, including the Washington Post and Wall Street Journal. He is available for interviews.


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