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Death of 'Kiddie Tax' disappointing for parents

­Many parents establish custodial investment accounts for their children. Typically, these funds are intended to be used for college. Alternatively, when the child reaches college age some parents transfer appreciated securities to the child and have the child sell the newly gifted asset in order to have that gain taxed at the child's lower tax rates. In the past there has been a potentially large tax advantage to these shifting techniques.

The tax advantage to shifting was two-fold. First, with custodial accounts, any interest, dividends or capital gains generated by the investments was taxed at the child's low tax rate. Oftentimes, this meant that the investment income would completely escape taxation during the childhood years. The shifting strategy's second advantage was that investment gains could be taxed at the child's rates when they were used to fund college.Several years ago Congress decided that children should not be used as tax shelters and thus was created the "Kiddie Tax." To limit the benefit of income shifting Congress added a tax on unearned income of certain children. As originally defined, this tax applied only to children who had not yet reached the age of 14. It limited the amount of income that could be taxed at the child's low tax rate and caused any excess to be taxed at the parent's rate.

For those parents who were using the strategy to save for college costs, this posed no problem as the kids would be 14 or older by the time the funds were needed for college and the tax would no longer apply. So, many parents continued to use the strategy.

Congress further expanded this tax in 2006 to apply to all children under the age of 18. This change left open the opportunity to shift gains to college-aged children since the Kiddie Tax was inapplicable once the child was 18. And for parents who had established custodial accounts much of the tax savings were still available as gains on liquidation would most likely occur in or after the year the child turned 18.

In 2008, the Kiddie Tax is further expanded to apply to full time students who are 19 through 23 whether or not the parent claims the child as a dependent unless the child provides more than half of his support via EARNED income. So, if your child is under 24 and a full time student, shifting of unearned income is of limited tax benefit as the amount that can be taxed at the child's low tax rate is limited to the first $1,700 of unearned income.

This tax law change is disappointing . . . especially for parents who were planning to take advantage of the zero percent capital gains tax rate that will apply to individuals in the 10 or 15 percent tax brackets in 2008. For those with younger children who wish to save for college costs, the best tax strategy may be the 529 plan. I'll tell you more about 529 plans in a future column." rel="gb_page_fs[]">Source SITE