IRS and Kiddie Tax

Hey, kid ... the tax man wants to see you
A new twist in the 'kiddie tax' erases any advantage of saving for college in your child's name, making 529s shine even brighter.
By Jeanne Sahadi, CNNMoney.com senior writer
June 13 2007: 11:09 AM EDT
NEW YORK (CNNMoney.com) -- Kids these days, they never seem to grow up ... at least in the eyes of the tax man.
The latest amendment to the so-called 'kiddie tax' now makes it officially a bad idea to save money for college in your child's name. The amendment will wipe out any remaining tax advantage of doing so.

And it doesn't cancel out - nor did the kiddie tax ever cancel out - the fact that assets in a child's name count more heavily than parents' assets in financial aid formulas, potentially reducing the amount a family gets.
The kiddie tax governs how a child's capital gains, dividends and interest are taxed. A portion (currently the first $850) is tax free, another portion (currently the next $850) is taxed at the child's tax rate (typically 5% to 10%), and anything beyond that threshold is taxed at the parents' rate.
The kiddie tax used to apply only to those under 14. Then it was changed to those under 18. And now, thanks to a law passed last month, they will be defined as those under 19 or full-time students under 24 who don't earn enough to pay for at least half their support.
In other words, the tax man will be getting a piece of more young adults' assets because the definition of child has now been expanded to include many under 24.
The whole point of the tax was to prevent high-income parents from sheltering their investments under the guise of giving it to their kids. But, of course, kids get money from other sources, too, said enrolled agent David Mellem, who is certified to represent taxpayers before the IRS.
Those sources include grandparents, wages from summer jobs, an inheritance or money from legal or insurance settlements intended to provide for a child's support. No matter. Under the kiddie tax, if it's in the kid's name, it's subject to the three-tier tax structure.
The new rule doesn't go into effect until 2008, which leaves about six months for those with custodial accounts or other accounts in their childrens' names to decide whether it makes sense to sell the assets.
Doing so will mean a bigger tax break: If your child is going to be 18 before the end of the year, under current law upon reaching 18 any assets sold in his name will be taxed entirely at his tax rates (which may be as low as 5% for capital gains and 10% for income). If you wait until next year, and your child will be under 19 or under 24 and a full-time student, a portion of his proceeds may be taxed at your income and investment tax rates.
Money earmarked for college may be put to better use in a 529 plan for three reasons:
If you or your child invest it in your state's plan you may get a deduction for your contribution
The money grows tax free and may be withdrawn tax free if it's used to pay for qualified education expenses
A 529 plan is treated as a parental asset if the parent is the custodian or owner of the account and the child the beneficiary, which can mean greater eligibility for financial aid. If the 529 is an account owned by the child's grandparents, that's even better since it won't count against the child at all when applying for financial aid, according to SavingforCollege.com, a 529 information source.
Mellem cautions, however, if you use proceeds from the sale of assets to fund a 529 and you, the parent, are made the custodian of the 529 and your child is a minor, you may have to prove moving the money from a child's account to a 529 is in the best interests of your child. That's because as custodian, the money is moved into your name and even though your child may be the beneficiary, his use of the money is now restricted to pay for education.
So to be safe, Mellem advises only putting new money for college savings in a 529.