The kiddie tax is a tax stipulation implemented by the government to prevent parents from taking advantage of their children’s lower income tax rate. The government wants to discourage families from using their kids as a safe zone for investment gains. The gift tax allows individuals to give up to $12,000, and married couples to give $24,000, without triggering the gift tax. Therefore, the kiddie tax discourages parents from giving their kids big chunks of investments so they don’t have to pay the higher tax bracket rates.
The kiddie tax has these basic rules:
– in fiscal year 2007, applies to children younger than 18
– applies to unearned income (investment income) more than $1700 (the first $850 of unearned income is tax free and the next $850 is taxed at the child’s lower tax rate)
– earned income like working a job does not apply to the kiddie tax because it is not a form of investment income
– in 2008, the kiddie tax will apply to children under 19 and college students under 24 (with exception of students who provide more than 50% of their support)
What this means?
Before the end of 2007, parents (who fit into the lowest two income brackets) needs to make sure to exploit the kiddie tax rules before changes occur in 2008 by giving the maximum allowable amount, without incurring the gift tax, to their children between 18 and 24 years old. Their children can then sell the unearned income before January 1, 2008 and only incur a 5% long term capital gain tax.
Here’s how the kiddie tax works this year. Let’s say that Robert and Lianna have a son named Nic who is 16. Their combined income puts them in the 28% tax bracket.
Robert and Lianna give their son $10,000 worth of appreciated stock. Nic sells the stock for an exact $1,700 profit (unearned income). Nic will pay nothing on the first $850 of profit and then 10% of the next $850 (via the 2007 federal tax rate). In conclusion, Nic pays $85 in taxes on the $1,700 investment gain from his parents which equates to a 5% total tax of the total unearned income.
Robert and Lianna give their son $10,000 worth of appreciated stock. Nic sells the stock for a profit of $3,000 and pays $85 tax on the first $1700. On the next $1300, the kiddie tax comes into play and is taxed the normal rate of Robert and Linda at 28% ($364 tax incurred). In conclusion, Nic pays $449 in taxes on the $3,000 gain from his parents which equates to a 15% total tax of the total unearned income.
While this isn’t something that benefits every family, it is always good to be aware of tax loopholes and ways to lessen what you have to give to the government. Why give more than you have to?