How to Avoid the Kiddie Tax

The IRS is making it even more difficult to shelter investment income in a child's name.

By + More

Your child may seem like a young adult, but the IRS may see a kiddie. And that can mean additional tax. The culprit is an expanding kiddie tax, a provision designed to block parents in a high tax bracket from shifting income-generating assets to a child in a lower tax bracket and thus reducing the family's overall tax liability.

Before a tightening in 2006, the tax targeted investment income of youngsters under 14 by making some of it potentially taxable at a parent's tax rate—as high as 35 percent compared with as little as 10 percent absent the kiddie tax. One popular tactic before 2006 was to put stock and other assets in a child's name and then have the child sell it at a low capital gains tax of 5 percent once 14 or older, compared with 15 percent for the parents.

But now the kiddie tax can hit through age 17. And for 2008, it can hit through age 18 or even through 23 for full-time students. Some exceptions apply, such as for older children who hold jobs and provide the majority of their own support, but the net is much wider.

"Giving stock to a child to sell at a low tax rate won't work as well," cautions Robin Christian, a tax analyst at publisher Thomson Tax & Accounting. At the least, the strategy may take longer to play out, she says.

The kiddie tax's longer reach can throw investment plans for a loop. Families with children emerging from the kiddie tax may have looked forward to a new zero percent tax rate next year on long-term capital gains for people in the bottom tax brackets, typically where young adults might fall. But now those older children may be back under the kiddie tax and face a 15 percent capital gains rate.

It may pay to advance to this year an investment sale planned for 2008.

That can be worthwhile for a young adult who is now out from under the kiddie tax but will return to being covered by it in 2008. One way to moderate the kiddie tax is to limit current taxable income by focusing on long-term growth and tax-exempt municipal bonds.

Silver lining: Some income can still be lightly taxed. The kiddie tax for 2007 doesn't apply until a child's income tops $1,700. For 2008, the trigger will be $1,800.

Not so silver: Boston accountant James Erdekian says it's now often more troublesome to do a child's return than that of the parents.