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Expanded 'kiddie tax' impacts savings strategy

You take advantage of every break you can to save for college. But what do you do when tax-rule changes suddenly throw you a curve ball?

For families concerned about the tab of higher education, the curve-ball question is now more than hypothetical.

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Teenagers with savings have just been handed a much bigger tax bill on all manner of investment income: dividends, interest and capital gains. The change comes because Congress just expanded the so-called kiddie tax, which requires youngsters to pay taxes at their parents' higher income-tax rates.

For some families that's a significant change. New rules closed a popular loophole that's been used to shelter savings frequently earmarked for a child's education, says Mark Luscombe, principal tax analyst at CCH, a tax information and software publishing firm.

"(Under the old rules), you could basically put money in a kid's name and it would be taxed at lower rates and you could spend it on college," says Luscombe. "Now that doesn't work."

How the 'kiddie tax' works
With the so-called "kiddie tax," children owe nothing on the first $850 (in 2006) of investment income earned. The second $850 is taxed at their rate. With the exception of Dakota Fanning and other pre-pubescent millionaires, that's usually a low 5 percent on dividends and long-term capital gains, and no more than 10 percent or 15 percent on short-term gains and interest. Investment income exceeding $1,700 is taxed at parents' tax rates -- 15 percent for dividends and long-term gains and up to 35 percent on interest and short-term gains.

Before the Tax Increase Prevention and Reconciliation Act went into effect in mid-May, kiddie taxes would have expired when teens turned 14, at which point they paid their own low rate on all investment income. Under the new law, all kids up to age 18 are subject to the system.

In fact, the expansion is retroactive to Jan. 1, 2006. Government accountants estimate it will generate $2.1 billion in revenues over the next decade.

Shifting strategies
While there are still plenty of smart ways to save, individuals now need to be mindful of pitfalls and maximize other savings options.

What to do and what to avoid:

1. Keep education money out of your kid's name.
It's not just their parents' tax rate that children have to worry about. "You really don't want assets in a student's name if you need financial aid," says Sandy Baum, a senior policy analyst with the College Board.

As it turns out, teens who've amassed hefty savings and investments are less likely to qualify for scholarships than kids whose parents retain those same assets. That's because in terms of financial aid, colleges use a funding formula that requires students to spend 35 percent of their savings on education. (The new Deficit Reduction Act calls for reducing the rate to 20 percent, but not until July 2007.) Parents have to devote less -- no more than roughly 6 percent of assets -- toward school costs. In other words, dollar for dollar, you get more financial help if parents stash education funds in their own names.

Next: "Want to shift savings to your children?"
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