Kiddie Tax Change

One provision in the tax bill signed by President Bush yesterday increases the age at which the so-called kiddie tax applies from 14 to 18. Under prior law, unearned income of minor children under age 14 was potentially taxable at the parents' tax rate, thus limiting the extent of tax savings that could be achieved by gifting investment assets to children.

The extension of preferred rates on long term capital gains and qualified dividends helps take some of the sting out of this rule. To the extent that a child's taxable rate on long term capital gains or qualified dividend income would otherwise only be five percent, gains above an exempt amount ($850 tax free, plus $850 more taxed at the child rate) are taxed at the parents' tax rate, which is likely to be 15 percent. For short-term capital gains and interest, however, the rate differential from the child (as low as 10%) to the parent (up to 35%) is much more significant.

In terms of tax planning, I recommend an excellent article in the May 17, 2006 Wall Street Journal by Jonathan Clements, "Teen Angst: How the New Tax Law Court Hurt Your College-Savings Plan". It can be found at page D1.

One important point that is worth mentioning about this provision: It is retroactive. Thus, if you sold a stock for your 14 year old this year, thinking you were past the effects of the kiddie tax and that the youngster would pay a five percent rate, not your fifteen percent rate, you may be surprised to learn that the bill applies to taxable years ending after December 31, 2005. (See section 510(d) of the bill.) Waiting may be hazardous, however, with the market acting like it has the past few days. And of course, if you wait past 2010, you may face yet higher taxes on capital gains, as these preferential rates expire then.

EAM