A nasty surprise for many taxpayers is masquerading under the harmless-sounding moniker "kiddie tax."
Beware, it may pack a wallop.
Children under 18 with unearned income, including certain college savings funds and other investments, are likely to owe more in taxes, thanks to a provision Congress made retroactive to January of 2006. That means an unexpected tax bite for parents who assumed they left that hurdle behind when their child turned 14.
"It's done a lot to destroy a lot of planning that a lot of people had done to fund education," said Donna LeValley, a tax attorney and contributing editor of the J.K. Lasser tax publications.
Before, only children under 14 with investment income were subject to the "kiddie tax" — the nickname for the part of the child's tax that must be figured at the parent's top rate instead of the child's rate, which is usually lower. Now, the kiddie tax is extended to children under 18.
"Parents may think their children have outgrown this provision," said Bob Scharin, senior tax analyst from Thomson Tax & Accounting who advises tax professionals. "That could be a big surprise to someone with a 16- or 17-year-old."
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.
Here's how the kiddie tax works: If a child is under 18, he or she is allowed to have $1,700 in investment income before the kiddie tax kicks in. (There's no tax on income of $850 or less, and the next $850 in income is taxed at the child's rate.)
For unearned income over $1,700, the child's tax is computed at the parent's tax rate. (But a child who turned 18 in 2006 or on Jan. 1, 2007, isn't subject to the kiddie tax for 2006 income.)
Parents who sold some of the child's investments early in 2006 — on the assumption that because the child was 14 or older the resulting capital gains would be taxed at the child's lower rate — will be disappointed. Because Congress made the kiddie tax change retroactive to Jan. 1, 2006, those gains are taxed at the parents' rate if unearned income exceeds $1,700.
You can choose to include the child's income on your tax return, provided the child's income is less than $8,500 and consists 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.