The massive Tax Reform Act of 1986 first introduced the concept of the "kiddie tax". For the next 20 years, any unearned income above a certain threshold earned by a child under the age of 14 was taxed at the parents' tax rate. The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) expanded the scope of this tax. In this article, we'll show you the positives and negatives to the new rules regarding the "kiddie tax"..

Tutorial: Education Savings Accounts

Socking Away Money for College
Understanding how children are taxed is very important when determining how to best save money for their college education. For 2011, the first $950 of net investment income earned by a child generally isn't taxed, and the next $950 is taxed at a rate of either 5% or 10%, depending on the type of income earned. To find out how to help your kids make and save money, see What Are You Teaching Your Kids About Money?

Any income above that $1,900 (for 2011) threshold is taxed based on your child's age as follows:

  • Children under the age of 18: Your child's net investment income earned during the year that exceeds the $1,900 threshold is taxed at your marginal tax rate.
  • Children over the age of 18: Your child's income is taxed using the same tables that apply to adults (filing single, if they are single, etc). For 2011, the first $8,700 of net taxable income is taxed at 10%, and then the next $26,650 ( $35,350 - $8,700) is taxed at 15%. As with all taxpayers, corporate dividends and long-term capital gains are taxed at a lower rate.

Also, starting in 2008, children as old as 23 may be taxed under kiddie tax rules if they are full-time students and their earned income provides at least half of their support. 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. (To learn more about saving for your kids, see Don't Forget The Kids: Save For Their Education And Retirement.)

Your child also can invest in buy-and-hold strategies to save money until they turn 18. Because your child can still make a wage (which is not covered by kiddie tax), he or she can also invest that money in shares, like growth stocks, that won't earn much or any income until they are sold, which should occur after the child turns 18. This allows the child to get the added bonus paying a lower capital gains rate on any securities that are liquidated.

There are other variables to consider as well. Investments made in a child's name may reduce the amount of financial aid available to your family. And 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 state's age of majority. (Don't forget that the Pension Protection Act of 2006 made tax-free distributions from 529 plans permanent.)

Reporting the Kiddie Tax
For 2011, if your child was under the age of 18 as of December 31 and earned more than $950 in interest, dividends, capital gains and other unearned income, you need to choose between the following two options when reporting that income to the IRS:

  • Form 8814: This form is used when electing to include your child's income on your tax return instead of preparing a separate income tax return for that child.
  • Form 8615: This form is used to calculate the kiddie tax when preparing a separate tax return for your child.

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.

It's a Balancing Act
Funding a child's education continues to get more complicated. As the tax rules continue to evolve, it remains unlikely that the government will increase funding for college education any time soon; therefore, 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.