The Kiddie Tax, introduced as part of the massive Tax Reform Act of 1986, celebrates its twentieth birthday by becoming even broader. Prior to 2006, any unearned income above a certain threshold earned by a child under the age of 14 was taxed at the parent's tax rate. Thanks to the Tax Increase Prevention and Reconciliation Act of 2006, the Kiddie Tax now applies to children 17 or younger who earn more than $1,700 (in 2006) in interest, dividends, capital gains, and other non-wage income.
Understanding how children are taxed is very important when determining how to best save money for their college education. For 2006, the first $850 of net investment income earned by a child isnít taxed, and the next $850 is taxed at a rate of either 5% or 10%, depending on the type of income earned. Any additional income is taxed based on your child's age as follows:
Now that the Kiddie Tax applies to children through age 17, it makes even more sense to save for your child's college education either in your own name or within a 529 Plan or Coverdell Education Savings Account (ESA). Previously, when the Kiddie Tax only affected children 13 and under, you had three or four years prior to your child's high school graduation to liquidate investments held in their name in anticipation of paying for college while still taking full advantage of the lower tax rates.
There are other variables to factor in as well. Investments made in a child's name tend to reduce the amount of financial aid available to your family. Plus, if your child receives a full scholarship or decides not to go to college, any money saved in that child's name becomes his or her property upon reaching your stateís age of majority. And don't forget that the Pension Protection Act of 2006 made tax-free distributions from 529 plans permanent.
Reporting the Kiddie Tax
For 2006, if your child is under the age of 18 as of December 31st, and earns more than $850 of interest, dividends, capital gains and other unearned income, you need to choose between the following two options when reporting that income to the IRS:
This year, you're only allowed to report your child's income on your tax return if your child's income is comprised of just interest, dividends, and capital gains distributions, and doesn't exceed $8,500.
For the most part, the taxes owed on your child's income will be similar whether you include that income on your tax return or prepare separate tax returns for each of your kids. One exception applies if your adjusted gross income exceeds $150k, since reporting additional income on your tax return might cause more of your itemized deductions and personal exemptions to phase out - possibly increasing the taxes you'll end up paying on your child's income.
It's A Balancing Act
Funding a child's education continues to get increasingly more complicated. As the tax rules continue to evolve, and with the government unlikely to increase funding for college education any time soon, saving for college has become a balancing act between tuition projections in excess of a quarter of a million dollars, an increasing array of confusing tax breaks for parents and students, and diminishing financial aid opportunities.
Since graduating from college in 1987, I have been a practicing tax accountant. On more than one occassion, I have seen the government enact legislation that reversed some of their previously instituted tax breaks. How confident are you that the government won't find some way to tax your Roth accounts down the road?
Three Major Reversals
The first reversal I observed was back in 1997 when the government increased the percentage of social security benefits that is taxable from 50% to 85%. Don't forget that you can't deduct the social security taxes you pay into the system each year, which means you'll essentially be taxed twice on any social security benefits you ultimately receive. Plus, when social security was first introduced, none of the benefit was supposed to be taxable.
Another reversal was part of the 2003 Tax Act. Under the pre-2003 rules, a new 18% capital gains tax rate was slated to take effect, but only for investments purchased subsequent to January 1, 2001 that were held for more than five years before being sold. So to be fair (and to raise tax revenues), the government allowed you to pre-pay taxes on your investments purchased prior to 2001 that had appreciated in value, even though those investments weren't actually sold.
Sounds like a great deal, right? It might have been, until President Bush signed the 2003 Tax Act into law. As part of this tax bill, Congress reduced the capital gains tax rate on investments held for more than one year to 15% through 2008 (which has since been extended through 2010). Anyone who elected to pre-pay taxes in 2001 on their investments did so at a rate of 20%, which is a whopping 33% premium over the new rate of 15%. Plus, they paid their taxes at least 2 years earlier than necessary.
The third reversal happened this year as part of Tax Increase Prevention and Reconciliation Act signed into law on May 17th. As part of this Tax Act, the "Kiddie Tax" age was increased from 13 to 17, retroactive to January 1, 2006. To make matters worse, in 2008, the capital gains tax rate for people in the two lowest tax brackets is slated to be zero percent. There are a lot of parents of college bound children who were saving money in their child's name in anticipation of liquidating those investments in 2008 and not paying any taxes. Now those investments will be taxed at the parent's rate unless the child is 18 or older.
The Roth Dilemma
After reading these three examples, how confident can you be that the government will not find a way to tax Roth IRAs down the road? Don't forget, with a Roth, you forgo a tax break today in anticipation of tax-free distributions in the future.
Let's take a look at some of the new Roth rules:
Reversal On Roth Accounts?
The theme of both of these new rules is simple. Pay taxes today, and the government promises that you won't be taxed on that money tomorrow. From what I've seen, if the rules change down the road, don't expect the IRS to refund to you any of the taxes you paid earlier than you otherwise had to.
Whether the government will somehow reverse this tax break down the road is anyone's guess. Even so, the level of confidence you have that the government won't change the Roth rules is something you need to factor in when deciding whether to go with a Roth 401k or to convert your IRAs and other retirement accounts to a Roth IRA in 2010.
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