'Kiddie tax' hitting many families

updated 3:05 p.m. ET April 2, 2008

WASHINGTON - If you have a child who turned 18 in 2007, you are in luck, taxwise. But that's the only bright spot for families burdened by the "kiddie tax."

The tax is, in effect, a penalty on parents who saved for their child's college by putting money into custodial accounts at a time when today's tax-free education savings vehicles weren't widely available or used.

"It has ruined wonderful planning people have been doing for years, people who were thinking ahead, who gave their child income-producing assets they would use when the kid went to school," said Harvey Aaron, senior tax manager at Braver PC in Newton, Mass., and director of tax services at Braver Wealth Management.

Here's how the kiddie tax works: If a child is under 18, he or she is allowed to have $1,700 in unearned income — non-wage income such as dividends and interest on investments — before the kiddie tax kicks in. (There's no tax on the child's income of $850 or less, and the next $850 in income is taxed at the child's ordinary income tax rate, usually 10 percent or 15 percent.)

For unearned income over $1,700, the child's tax is computed at the parent's tax rate, which can be as high as 35 percent. A child who turned 18 in 2007 isn't subject to the kiddie tax and will pay 2007 tax at his or her lower rate.

But don't celebrate too much. Congress has raised the age at which children are subject to being taxed at the parents' rate. For 2008 income, the kiddie tax will apply to children under 19, and even those under 24 if they are full-time students and don't have earned income equal to half of their annual support.

Shifting income to children in lower tax brackets is a strategy long used by the wealthy to reduce their tax, and Congress took aim at that practice when it passed the kiddie tax nearly 20 years ago.

MORE FROM TAX TACTICS

Tax Tactics Section Front

Senate panel hears about European tax havens House OKs alternative minimum tax relief IRS raises the amount deductible for mileage IRS says up to 350,000 tax rebate checks wrong Taxpayers with foreign spouses miss rebates Amazon suing New York state over sales tax law Retailers entice shoppers to spend rebates Paying taxes costs $207 and a day of work Fewer big companies getting audited by IRS States crack down on tax-free online purchases Tax Tactics Section Front   Add Tax Tactics headlines to your news reader: