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Dealing with the new college-kid tax
by Joe Hurley, founder, Savingforcollege.com
Sunday, June 24th 2007

[Updated March 13, 2008]

You're not alone if you have school-aged children and feel you've been blindsided by Congress. Under legislation signed by President Bush in May 2007, families with investments in their children's names face a new "college-kid tax" in 2008. In this article, I'll describe the new tax along with the actions you can take to protect you and your children from falling into its grasp.

First, a little history. Before 2006, the kiddie tax hit only those children under the age of 14. But as of January 1, 2006, the tax was expanded to children under the age of 18. Many families were surprised and dismayed by the 2006 change, having already made gifts to their children under a college-savings strategy designed to take advantage of their lower tax brackets. Their original plans to begin liquidating the investments once the child reached 14 had to be re-examined as the gains would now be taxed at the parents' tax rates. Some families changed course, deciding to wait until age 18 before triggering the gains even when it meant hanging on to investments that should have been sold.

Beginning in 2008, the kiddie tax is expanded again, this time to children age 18 and to full-time students ages 19 to 23. For children under the age of 18, there are no changes to the current kiddie tax. But for the new target group, the kiddie tax can be avoided if the child receives more than one-half of their own support through earned income (wages, etc.).

(Technical note: Whenever discussing age and the kiddie tax, it's the child's age as of December 31 that determines if the tax applies for that year. Children born on January 1 are included with those born on December 31, the day previous.)

Here's what you can do if your children have investments in their names:

If your child will be 16 or younger on December 31, 2008

You have at least two more kiddie-tax years. You can take advantage of the kiddie-tax income allowance by reporting as much as $1,800 in unearned income (capital gains, dividends, interest) each year. The first $900 is tax-free thanks to the dependent's standard deduction. The next $900 is subject to your child's 10-percent federal tax bracket, except that capital gains at that level are taxed at a 0-percent in 2008 through 2010.

You might think about finding ways to spend your child's money for his or her benefit as permitted under the UGMA/UTMA laws in your state. By removing the child's assets, you'll be reducing future kiddie-tax exposure, improving financial aid prospects, and minimizing the chances that your internet-savvy child discovers the pot of cash awaiting him or her at age 18 or 21 and makes some less-than-desirable, life-defining decisions.

In building your college-savings fund, steer towards 529 plans in place of taxable investments. Since the earnings grow tax-deferred in a 529 plan, and come out tax-free when used to pay for college, the kiddie-tax becomes a non-issue. You'll also be better positioned for federal financial aid if your assets, or your child's assets, are in a 529 plan.

If your child will be 18 on December 31, 2008

The new law smacks you hard. You were looking forward to getting beyond the kiddie tax as of January 1, 2008 only to discover that your child now remains subject to it. The suggestions offered above for younger children will continue to apply in your situation, but with two major differences. One difference is that the expanded kiddie tax will not apply to your 18-year old if he or she earns more than one-half their own support. If you own your own business, you may want to start planning now for a new family worker next year.

The other difference has to do with financial aid. You are now in the "base year" for the 2009 financial aid application, and the income reported by your child may cause a significant drop in eligibility. Any income-tax planning moves should keep financial aid consequences in mind.

If your child will be 19 to 23 years old on December 31, 2007

You're in the same situation as the 18-year described above, except your child has one more kiddie-tax escape hatch: if he or she is not a full-time student for at least five months during the year, the kiddie tax does not apply.

As mentioned above, if your child is applying for financial aid, be mindful of the consequences when triggering gains. And make the effort now to determine if your child has any chance of qualifying for the kiddie-tax exemption next year by working and earning more than one-half his or her support. This determination will have a significant impact on your planning.

"We see a tremendous inflow to 529 plans as families re-think their college-savings strategies and decide the 529 plan offers the best escape from the kiddie tax. While limited opportunities will still exist to maintain taxable investments in your child's name, managing those investments while avoiding the kiddie tax has become an extraordinarily difficult task."

» Claiming a state income tax deduction - 12/20/16
» Understanding 529 Investment Options - 12/13/16
» Should you open an UGMA/UTMA 529? - 02/06/08
» Understanding your state's slice of 529 fees - 12/13/07
» Planning for the new "kiddie tax" - 10/30/07
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