Kiddie Tax Gets Worse
by Gerald Townsend, Financial Editor
July 2007

The "kiddie tax" is not just for kids anymore. The tax originally applied only to children under the age of 14 who had unearned income (e.g. interest and dividends) that exceeded certain levels. Last year, a tax law change raised the age threshold from 14 to 18 and starting in 2008, the age will rise yet again, applying to children under the age of 19 and to dependent full-time students under the age of 24. Don't kids ever become adults?

For 2007, the kiddie tax only applies if a child's investment income exceeds an inflation-adjusted threshold of $1,700. The first $850 of investment income is not taxed at all (federal tax) and the next $850 is taxed at the child's own tax rate, which could be as low as 5% or 10%, depending on the type of income. However, once the investment income exceeds the $1,700 threshold, it is taxed at the parent's marginal (highest) tax rate.

Many taxpayers have established custodial accounts (Uniform Transfer to Minors) for their children. In these plans, a parent is normally the custodian and a child is the beneficiary. With the tax changes of this past year, these custodial accounts will no doubt be used infrequently in the future. If the balance of the custodial account is small (less than $5,000) they may still be OK, since the investment income probably won't be enough to exceed the thresholds, but why take the risk when there are other alternatives.

While custodial accounts are the losers in this tax change, Educational Savings Accounts (ESAs) and 529 Plans are the winners.

With an ESA or a 529 Plan, investment earnings are not taxed during the accumulation phase. They are also not taxed during the distribution phase, as long as the distributions are for qualified expenses.

So, if you are reading this and kicking yourself for having done such a good job of accumulating money in a custodial account, what should you do now? Here are some thoughts:

• First, make no further contributions to your custodial account. Begin funding an ESA or a 529 instead.

• Next, if your child is over 18, but under 24, consider triggering capital gains in 2007, since the new law extending the kiddie tax age isn't effective until 2008.

• If the assets in the custodial account are mainly in bank accounts or if there are no significant unrealized capital gains, consider liquidating the assets and moving the cash into a 529 Plan. This will protect future investment earnings from the expanded kiddie tax.

• If you do decide to move money from a custodial account to a 529 Plan, you might first want to consider if there are any purchases you should make first. Withdrawals from a 529 Plan (or ESA) can only be made tax-free if the withdrawal is for certain qualified expenses. However, withdrawals from custodial accounts can be for any "non-support" purpose, such as buying a car for your child or sending them on an overseas vacation.


Gerald A. Townsend, CPA/PFS, CFP^®, CFA^® is president of Townsend Asset Managment Corp., a registered investment advisory firm. Email: Gerald@AssetMgr.com