Coping with the Expanding Kiddie Tax

By: Arthur F. Dicker, Esq.

            Many families utilize Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) accounts to save for their children’s college education.  Such accounts are deemed to be owned by the child for whom they are established, with the parent acting as “custodian” for the child’s funds until the child reaches age 18 or 21.  

            Until 2006, the Internal Revenue Code taxed income from such accounts at the child’s own tax rate, as long as the child was under age 14 by the end of the year.  Congress amended the Code in 2006, retroactive to the beginning of the year, to apply the “kiddie tax” to a minor’s income until the year he or she turns 18.  See June 2006 Tax Planning E-Letter (“New Tax Act Holds Some Surprises”).

            Under the kiddie tax, the net unearned income of a child (for 2007, generally unearned income over $1,700) is taxed at the parents’ tax rates if the parents’ tax rates are higher than the tax rates of the child.  (The $1,700 figure is adjusted for inflation periodically).  Thus, interest earned on UTMA or UGMA accounts might be taxed at rates of 25% or higher, instead of the child’s lower rate of 10% or 15%, for example.   Qualifying dividends and long-term capital gains might be taxed at the higher rate of 15% instead of the child’s lower rate of 5%, for example.

The Kiddie Tax is Growing Faster than the Kids are!

            Now with the Small Business and Work Opportunity Act of 2007, Congress has expanded the reach of the kiddie tax again.  Beginning in 2008, the kiddie tax will apply to children age 18 and to those over 18 but under age 24 who are full-time students, if their earned income doesn’t exceed one-half the amount of their support.  Suddenly, the unearned income of most college students, above a certain amount, will be subject to the kiddie tax rules, starting next year.  

            Families who have stockpiled savings for college expenses in their children’s names will now be faced with higher tax rates on the income from such accounts and on capital gains when they liquidate investments to pay for college.  This expansion of the kiddie tax should encourage parents who have time to plan ahead to make greater use of Section 529 plans to save for college.  Earnings in such plans are exempt from federal income tax as long as the proceeds are eventually used for qualified higher education expenses.  See December 2006 Tax Planning E-Letter (“IRC Section 529 Plan Benefits Made Permanent by the Pension Protection Act”) for more information about 529 Plans.

Window of Opportunity

            Because the expanded version of the kiddie tax does not kick in until 2008, there is a brief window of opportunity for families with students ages 18 to 22 until the end of this year.  They could liquidate investments in 2007 and pay capital gains tax at the student’s tax rate.  They could also shift savings from the student’s name to a 529 plan now to avoid the imposition of the kiddie tax on unearned income beginning next year.  (Contributions to 529 plans must be in cash, so it is not possible to “roll over” existing investments into such plans without liquidating them first.)

If you have any questions about the matters discussed in this e-letter, please contact Louis W. Pierro or Arthur F. Dicker at (518) 459-2100.  Prior Tax Planning E-Letters may be accessed at www.pierrolaw.com.

**To the extent the preceding text contains an opinion on one or more Federal tax issues, such opinion was not written to be used and cannot be used for the purpose of avoiding penalties.  If you would like a written opinion on the Federal tax issues addressed in this email, upon which you can rely for the purpose of avoiding penalties, please contact our office.