The Kiddie Tax Continues to Grow
Under the new tax law passed earlier this year—the Small Business and Work
Opportunity Tax Act of 2007—Congress extended the reach of the so-called
“kiddie tax.” Now this onerous tax provision might begin to affect families
with children well into their twenties.
Background: Normally, income is taxed to the person who receives it at his
or her ordinary income tax rate. However, unearned income received by a
child may be taxable at the top marginal tax rate of the child’s parents to
the extent it exceeds an annual threshold. In other words, instead of being
taxed at a child’s low tax rate (usually either 10% or 15%), the effective
rate on the income may be as high as 35%.
The annual threshold is adjusted for inflation. For 2007, the limit is
$1,700 (unchanged from 2006). The first $850 is tax-free; the next $850 is
taxed at the 10% rate. Reminder: The tax only applies to unearned income
(such as capital gains, dividends and interest). Any other income your child
earns is exempt from the kiddie tax.
Prior to 2006, this kiddie tax provision only applied to children under the
age of 14. Then a major tax law passed last year raised the age limit to age
18. Now the new law extends the kiddie tax to older children.
New tax rule: Beginning in 2008, the age limit is increased to age 19 or age
24 for full-time students. These higher age limits apply if the child
doesn’t have earned income equal to half of his or her annual support. In
other words, you can’t avoid the kiddie tax just because you are no longer
claiming the child as your dependent.
Keeping this change in mind, here are several possible ways to reduce the
impact of the kiddie tax.
-
Monitor your child’s investment income. If you are careful to stay below the $1,700 fault line, you will not have any kiddie tax problems at tax return time. For instance, in 2008 you might buy CDs for the child that will not mature until 2009.
-
Emphasize tax-deferred investments. Instead of investments that produce current income, shift more of your child’s portfolio into long-range vehicles such as growth stock. Similarly, if you buy U.S. Savings Bonds in the child’s name, he or she doesn’t have to pay any current tax.
-
Switch some investment dollars into municipal bonds. Generally, there are no federal tax consequences for investments in municipal bonds or municipal bond funds. Reason: The income received is exempt from federal income tax.
-
Employ your own child (assuming you’re in a position of authority). Since the wages are earned income, the kiddie tax doesn’t apply. Assuming the child is paid a reasonable amount for the services actually performed, the business can deduct his or her salary.
Despite the new law change, you may be able to avoid dire tax consequences
with astute advance planning. Seek professional advice for your own family.
We have several professionals at Somerset that can help--please
contact us.
Wherewithal
is provided by Somerset for our clients and other interested persons
upon request. Since technical information is presented in generalized
fashion, no final conclusion on these topics should be made without
further review. For additional information on the issues, please
contact
a member of the firm. Somerset provides total financial solutions,
including accounting, assurance, information solutions, litigation &
valuation, tax, wealth management and management consulting services to
entrepreneurs and their businesses. This document is not intended or
written to be used, and cannot be used, for the purpose of avoiding tax
penalties that may be imposed on the taxpayer.
Somerset CPAs,
P.C.
3925 River Crossing Parkway, Third Floor
Indianapolis, Indiana 46240
317.472.2200 • 800.469.7206 • FAX 317.208.1200
www.somersetcpas.com
.jpg)