Change In The 2006 ‘Kiddie Tax’

Whether you are using child investment income as a tax strategy or because your child truly has investment income, you need to be aware of a BIG change that has occurred for the 2006 tax year.

The “kiddie tax” as it is usually called, in previously years was a tax on unearned income greater than $1,700 for children younger than 14.

This income typically only includes investment, dividend and interest income, rents, and royalties. The income would be taxed at the parent’s top rate, instead of the child’s tax rate, which is usually lower.

The kiddie tax was a way to prevent the shifting of income from the parent to a child, which would result in earnings subject to a lower tax rate. However, many parents used investment income as a way to set aside funds for a child’s education.

Due to a change implemented by Congress, the age that the Kiddie tax applies to has been increased to 18 years old in 2006.

This means for children 18 and younger:

• Unearned income up to $850 is not subject to tax
• The unearned income from $850 – $1,700 is subject to the child’s tax rate
• All unearned income greater than $1,700 is subject to the parent’s top tax rate

It is important to recognize this change, as many people may have thought this tax disappeared when their child turned 15.

As parents, you have 2 options:

1. Include the income on the parent’s tax return
2. Prepare a separate tax return for your child

Including the child’s income on your own tax return (as long as it is less than $8,500) will reduce the amount of paperwork you will have to complete, but it also adds to your taxable income and will affect the applicable phase-outs.

If you are seeking a way to fund a child’s education, one vehicle for this is a 529 plan. This plan allows investment earnings to grow tax free if the money is earmarked for higher education.