The expanded "kiddie tax" and the financial aid trap.

• Author: Sumutka, Alan R.

Section 510 of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) expanded the "kiddie tax" from children under age 14 to those under age 18, starting in 2006. Not only can the increase in age affect a family's income taxes, but it might also adversely affect a child's college financial aid awards.

Considerations

Pre-TIPRA law and planning: Special rules under Sec. 1(g) (the kiddie tax) are designed to minimize the family income tax advantage obtained when (1) parents gift assets to a child, (2) the investment income is taxed at the child's lower income tax rates and (3) family wealth increases. Before the TIPRA, Sec. l(g) provided that a child under age 14 who had unearned income (e.g., interest, ordinary dividends, capital gains, etc.) in excess of $1,700 (in 2006) was taxed at the parents' highest marginal income tax rate, but only if the child had a living parent at the end of the year and the tax at the parents' rate exceeded the tax at the child's rate. Under Sec. 1(g)(3), if a child's unearned income included net capital gains and/or qualified dividends, it was allocated between the parent and the child (because, under Sec. l(h), different capital gain/qualified dividend income rates of 15% or 5% (0% from 2008 -2010) apply).

Because the kiddie tax is imposed only on unearned income in excess of $1,700, unearned income below that threshold is taxed at the child's rate. Thus, a well-publicized and effective pre-TIPRA strategy was to purchase no-, low- or deferred-income-generating investments (e.g., growth stocks or U.S. Series EE/I savings bonds) for a child under 14. When the child attained age 14 or more, the assets were typically sold or redeemed, because the tax no longer applied.

Post-TIPRA law and planning: For tax years beginning aider 2005, the kiddie tax applies to a child under age 18, under Sec. l(g)(2)(A), but not to one who is married and files a joint return; see Sec. 1(g)(2)(C).

The current planning wisdom appears to be the same as the pre-TIPRA strategy, except that investments should now be held until the child is at least 18, then disposed of. Although the opportunity to lower taxes by transferring income-producing assets to children under 18 is curtailed by the kiddie tax, putting a child's funds in investments that produce little or no current taxable income can help avoid the tax; see RIA's Complete Analysis of the Tax Increase Prevention and Reconciliation Act of 2005, [paragraph] 204.

Further, parents who had planned to sell a child's college stock portfolio in 2006 when the child reached 14 now have to wait if they intend to take advantage of the latter's lower tax rate. If the parents plan to postpone a sale until 2008 when the child's capital gain...