Avoiding the kiddie tax

(FSB Magazine) -- A midwestern tool and die maker's daughter had worked hard for her father's business over the years, which helped her save about $42,000 for college. However, a recent change in the federal "kiddie tax" law raised the age at which a child's money is taxed at her parent's rate. As a result, the savings the daughter withdrew to pay for her first semester at Loyola this fall were taxed at a much higher rate.

Moreover, the same high tax rate will be applied to her withdrawals until her college account is depleted, which should take about two years. "My daughter worked and saved, but we got less money," says her mother, who does the family's finances and wishes to remain anonymous. "The cost of education is unbelievable. When you've saved a long time, you think you will have enough money by the time your child goes to college, but now we just have a percentage of it, and it's all because of the kiddie tax changes."

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The Small Business and Work Opportunity Tax Act of 2007 does offer some juicy tax breaks to entrepreneurs. But it also includes a potential headache: an expansion of the kiddie tax, which limits the amount of investment wealth that parents can shift to a child to take advantage of the youngster's lower tax rate. In tax year 2007 your child can report only about $1,700 of passive investment income before triggering your tax rate (the amount rises annually with inflation). Congress is also tinkering with the age limits. In 2006 the cutoff age for kiddie tax purposes was increased from 14 to 18; the latest change, which takes effect in tax year 2008, raises the age to 19 - and up to 24 for full-time students.

"What the age expansion really does is pull the rug out from under a popular college-savings vehicle," says Dave Demming (demmingfinancial.com), a certified financial planner in Aurora, Ohio, who caters to small-business owners, many of whom have used UGMA (Uniform Gift to Minors Act) accounts to build tuition nest eggs.

The UGMA strategy involves transferring growth investments, which typically don't throw off much income, to a child's account. It's unlikely the account will generate investment income beyond the kiddie tax ceiling - and income below that ceiling is taxed very gently: The first half is tax-free, and the second is at the child's low tax rate. Once the child passes the kiddie tax age limit, capital gains are harvested and taxes are paid at the teenager's capital gains rate, which could be as low as 5% in 2007. But the new rules mean that gains beyond the $1,700 limit will be taxed at your 15% rate, and income by as much as 35%.

While the new rules undo the UGMA strategy, there is a potential solution for small-business owners: If your child is over 18 and his earned income exceeds half of his "support" (your calculation of what it costs to house, feed, and clothe him), the higher tax rates won't apply.

In other words, hire the kids in your business, raise their earned income, and "lower the risk that they'll trigger the kiddie tax," says Michael Kitces, director of financial planning at Pinnacle Advisory Group (pinnacleadvisory.com) in Columbia, Md. Kitces cautions that the support rule is a fuzzy one and that you may need to explain your calculation in an audit. (An IRS guide on how to calculate support for a variety of purposes can be found at irs.gov/pub/irs-pdf/p501.pdf.)

The IRS also scrutinizes employment arrangements, so paying your college-age daughter a vice president's wages for summer work won't fly. "If you start employing your children while they're young, you have more justification for paying a higher wage later on because they have experience," notes Demming. Also, once your child's earnings hit $31,850 (in 2007), capital gains will be taxed at 15%, just like yours.

There's an added incentive to sidestep the kiddie tax. From 2008 through 2010, the capital gains tax rate will drop to zero for filers in the lowest income tax bracket, which includes most kids.

If family employment isn't an option, there's another way to beat the tax: Cash out UGMA portfolios before Dec. 31, 2007, and if your child is 18 or older, only his tax rates will apply.

MONEY TIPS

Playing With the New Kiddie Tax

The new federal "kiddie tax" limits the amount of investment wealth parents can shift to a child to take advantage of the youngster's lower tax rate. Here's how it works.

YOU ARE ELIGIBLE FOR A TAX BREAK IF:

1. In tax year 2007, your child reports under $1,700 in passive investment income (amounts over that trigger your tax rate).

2. In 2006 your child was 18 or younger. In tax year 2008 the age rises to 19 years (up to 24 for full-time students).

STRATEGIES:

1. Transfer growth investments, which don't throw off much income, to a child's account.

2. Hire your child. If she is over 18 and her earned income exceeds half of her "support" (your calculation of what it costs to house, feed, and clothe her), your higher tax rates won't apply: that is, put the kid to work in your business, raise her earned income, and lower the risk she'll trigger the kiddie tax.