If you have a child who turned 18 in 2007, you are in luck, taxwise. But that's the only bright spot for families burdened by the "kiddie tax."
The tax is, in effect, a penalty on parents who saved for their child's college by putting money into custodial accounts at a time when today's tax-free education savings vehicles weren't widely available or used.
"It has ruined wonderful planning people have been doing for years, people who were thinking ahead, who gave their child income-producing assets they would use when the kid went to school," said Harvey Aaron, senior tax manager at Braver PC in Newton, Mass., and director of tax services at Braver Wealth Management.
Here's how the kiddie tax works: If a child is under 18, he or she is allowed to have $1,700 in unearned income — non-wage income such as dividends and interest on investments — before the kiddie tax kicks in. (There's no tax on the child's income of $850 or less, and the next $850 in income is taxed at the child's ordinary income tax rate, usually 10 percent or 15 percent.)
For unearned income over $1,700, the child's tax is computed at the parent's tax rate, which can be as high as 35 percent. A child who turned 18 in 2007 isn't subject to the kiddie tax and will pay 2007 tax at his or her lower rate.
But don't celebrate too much. Congress has raised the age at which children are subject to being taxed at the parents' rate. For 2008 income, the kiddie tax will apply to children under 19, and even those under 24 if they are full-time students and don't have earned income equal to half of their annual support.
Shifting income to children in lower tax brackets is a strategy long used by the wealthy to reduce their tax, and Congress took aim at that practice when it passed the kiddie tax nearly 20 years ago.
But the wealth-shifting strategy was also a way for middle-income parents to save for children's college expenses.
Nowadays, many parents choose as college savings vehicles the popular 529 plans, which allow earnings to grow tax-free when the money is used for higher education. But 529s weren't as widely available when parents of today's older teens started saving. Instead, those parents typically saved for college by putting money into custodial mutual funds, bonds or other savings instruments in the child's name.
It's the return on those investments — the "unearned" income that includes interest, dividends, rents, royalties and profits on the sale of property — that falls under the kiddie tax. The tax doesn't apply to wages a child earns at a job.
That brings up one strategy some parents with their own business have adopted: hiring their children to work for them. This gives the child earned income, which is taxed at the child's ordinary income tax rate.
But it's best to be cautious with that strategy, notes Mark Steber, vice president of tax resources at Jackson-Hewitt, the nationwide tax preparation company.
"You can't pay them $20,000 a year for coming in and filing folders, but you're also not precluded from hiring children," Steber said. "I would caution people not to think that's a loophole the IRS is not aware of. You can't jack up earned income for something that's unreasonable."
You can choose to include the child's income on your tax return, provided the child was under 18 at the end of 2007 and had income less than $8,500 that consisted only of interest and dividends or capital gains distributions on those investments. Reporting the child's investment income on your return may reduce paperwork and costs; since the child doesn't file a return, tax preparation expenses may be reduced.
But including a child's income on your return also adds to your adjusted gross income, which in turn may subject you to phase-out or reduction of certain exemptions, deductions, IRA contributions and other tax breaks, as well as increase your state and local tax liability.
Whichever tax-filing strategy you choose, be sure to file the correct forms: Form 8814 is attached to the parent's return when a child's investment income is reported with the parent's income. When the income is reported on a child's separate tax return, Form 8615 is filed with the child's return and no additional form is filed with the parent's return.
Also, remember that a child who files a tax return cannot claim an exemption for himself or herself if the parent or someone else can claim the child as a dependent.
For more information, see IRS Publication 929, "Tax Rules for Children and Dependents."