The New Kiddie Tax

For many middle-class families, the hoopla about new "kiddie tax" rules -- which expand the number of years during which a child's investment income can be taxed at the parent's rate -- is much ado about nothing. That's because most custodial accounts, especially in the early years, are simply too small to generate enough annual investment earnings to trigger the tax.

Due to a retroactive change approved by Congress, the kiddie tax now applies until the year a child turns 18 rather than disappearing on the child's 14th birthday. For 2006 and 2007, the parent's rate applies to a child's investment income in excess of $1,700. To generate that much income, your child's account would have to hold about $25,000 and earn an annual return of 7%. The first $850 of a child's investment earnings remain tax-free, and the next $850 is taxed at the child's rate -- likely 10% for interest income and just 5% for long-term capital gains and qualified dividends. (The parent's rate can run as high as 35%.)

The new rule could throw a monkey wrench into parents' plans to give their children stock or other appreciated assets with the goal of shifting the tax on the gain to a lower tax bracket. That'll still work, but only if the child waits until the year he or she turns 18 to sell the securities.

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This strategy takes on special appeal beginning in 2008 if your child is at least 18. That's when long-term capital gains become tax-free for those in the two lowest income-tax brackets (with taxable income under about $33,000). Give appreciated stock to your kids and they'll pay no tax on the gain as long as they are 18 or older and sell the shares in 2008, 2009 or 2010. "It's a nice bonus if your children are the right age at the right time," says Bill Fleming, a tax expert with PricewaterhouseCoopers.

If you're concerned that your child's college fund may grow big enough to trigger kiddie-tax headaches down the road, you have another option: Cash out the custodial account and transfer the money to a state-sponsored 529 college-savings plan, which lets your savings grow tax-deferred. Distributions escape federal taxes if you use them for qualified college expenses. If you're just starting to save for your child's education, the 529 plan wins out over custodial accounts.

There's no federal tax deduction for 529 contributions, but some states offer tax breaks to residents. In Connecticut, for example, married couples can deduct 529 contributions up to $10,000 ($5,000 for individuals), regardless of their income. With a 5% state income tax, that would save $500 in state taxes.