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TAX TIP #65
The kiddie tax: IRS rules for child's investment income

Because of changes to the "kiddie" tax, the name of the rules governing the tax rates applied to younger investors' income probably should be changed. The age at which a child's usually lower rates kick in now is much higher, meaning the tax bills on such accounts also will be higher, too.

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The kiddie tax was created in 1986 to keep parents from sheltering income by putting accounts in the names of their lower-taxed kids. In it's original form, a portion of investment earnings held by a child was tax free.

Another portion of earnings was taxed at the youngster's tax rate.

Any amounts over that second earnings threshold were taxed at the parent's highest marginal tax rate, which could be as high as 35 percent.

Relief arrived once the child turned 14. Then the excess earnings were again taxed at the child's lower rate.

Upping the age and the ante
On May 17, 2006, however, the kiddie tax effectively grew up. On that day, the Tax Increase Prevention and Reconciliation Act took effect with a provision that keeps the parent's tax rates in effect until the youngster turns 18.

Now a young account holder has to wait four more years to take advantage of his or her lower tax bracket. And by that time, the youth is usually out of high school and possibly earning enough at a part- or full-time job to no longer be in the lowest tax bracket.

Compounding the tax cost is the law's retroactive effective date of Jan. 1, 2006. Since the change didn't come until May, parents who rebalanced the youngster's portfolio before then, expecting any taxes to be levied on gains at the child's lower rate, suddenly found themselves owing more.

Two-tiered structure remains
The age changed, but the basic dual tax structure for children's investment accounts remains the same.

Children still can receive a portion of unearned income tax-free. For 2006 returns, the limit is $850, meaning that a child doesn't have to pay taxes on any interest, dividends or capital gains up to this amount.

The child does have to pay taxes on the next $850, but at his or her lower tax rate.

Once those 2006 earnings exceed $1,700, however, the preferential treatment ends. The earnings on those excess earnings are taxed at the parent's top marginal tax rate, rather than at the usual 15 percent capital gains rate.

Choosing whether child or parent files
To figure a child's tax in this case, you'll have to fill out Form 8615 and attach it to the youngster's federal income tax return. If you and your spouse file jointly, the IRS wants the name and Social Security number of the parent who is listed first on the return so that it can ensure your child's tax is figured at the rate applicable to your joint income.

If you are married, but file separately, the name and tax ID number of the parent with the higher taxable income must be entered on Form 8615. It gets more complicated for parents who are separated, unmarried, treated as unmarried for tax-filing purposes or remarried. Check the Form 8615 instructions for details if one of these situations applies to your family.

Some parents save their child from tax-filing duties by reporting the youngster's investment income on the adults' return. This is an option if a child's earnings are only from interest and dividends, including capital gain distributions, and are less than $8,500. In these cases, the child's investment income is detailed on Form 8814, Parents' Election to Report Child's Interest and Dividends, and included with the parents' tax return. This way, the child doesn't have to file a return or Form 8615.

Child's income could cost parents tax breaks
Keep in mind, however, that when a parent adds a child's income to the adult's return, that extra money could mean the loss (or at least a reduced benefit) of some tax deductions and credits that are phased out as income grows.

You should run the numbers on both Form 8615 and Form 8814 to guarantee that you, and your child, pay the least possible tax on the youngster's investment earnings. If you have more than one child with unearned income, you must repeat this process for each youngster.

And remember, these tax rules apply only to investment income received by children who are younger than 18 at the end of the tax year. (For kiddie tax age purposes, the IRS considers a child born on Jan. 1, 1989, to be 18 years old at the end of 2006. That prevents the youngster's investment income from being taxed at his or her parents' higher rate.) Wages and other earned income received by a child of any age are taxed at the child's normal rate.

More details on filing requirements for children can be found in IRS Publication 929, Tax Rules for Children and Dependents.

Freelance writer Kay Bell writes Bankrate's tax stories from her home
in Austin, Texas, and blogs on tax topics at Don't Mess with Taxes
.

-- Updated: March 30, 2007
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