Beware the New Kiddie-Tax Rules

My daughter turns 18 on December 25, and I have two questions regarding the kiddie tax. If we sell mutual funds from her custodial account this year, can we still get a tax break before the new kiddie-tax laws go into effect? And do I have to sell the funds after she turns 18 (which would give me five days at the end of the year to do it), or can I sell them any time during the year that she turns 18?

Good news on both questions: You can sell your daughter's mutual funds this year and take advantage of her lower tax rates before the new law goes into effect in 2008. And you can sell the investments anytime during the year.

Under the kiddie-tax rules, children's investment income over a certain limit is taxed at their parents' rate rather than the child's lower rate (the long-term capital gains rate, for example, is generally 15% for parents vs. 5% for most children). Before 2006, this applied only to children younger than 14. But Congress increased the age limit twice in the past two years.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

This year, the law affects children younger than 18. Now, the first $850 of a child's investment income is tax-free and the next $850 is taxed at the child's rate. Investment income in excess of $1,700 is taxed at the parents' higher rate if the child is 17 or younger (the year they turn 18, investment income over that limit is taxed at their own rate). And Congress recently passed a law that increased the age yet again, but the new rules won't affect families until next year. Starting in 2008, the kiddie tax will be expanded to include dependents younger than 19 and dependent full-time students younger than 24. For more information about the rules, see Congress Closes Kiddie-Tax Loophole.

So you ask your question at a key time. People with children who are age 18 to 23 by the end of this year may want to sell some assets from their kids' custodial accounts in 2007 to take advantage of the lowest 5% capital-gains rate for investments held for more than one year. And that includes you. It's the child's age by the end of the year that counts under this law -- even if your kid squeaks by with less than a week to go before New Year's Eve. So your daughter is considered to be 18 for this full year, which means that investment income she earns above the $1,700 limit in 2007 (including profits on the funds she sells) will be taxed at her own rate rather than yours -- even if she sells the funds before her birthday.

You do need to be careful with the income limits, however, if your daughter's funds have increased in value significantly through the years. "If her account has substantial appreciation, the family should keep in mind that the 5% tax rate on long-term capital gains applies only to the extent an individual's income falls within the levels for the 10% or 15% regular income-tax brackets," says Bob D. Scharin, RIA senior tax analyst for Thomson Tax & Accounting. "In 2007, the regular income-tax bracket for unmarried individuals tops out at taxable income of $31,850. To the extent capital gains causes the daughter's income to exceed this level, the excess would be taxed at a 15% rate even though the kiddie tax would not apply."