Who said it’s easy being a kid? The problems are many – running the gamut from peer pressure to parents who “just don’t understand.”
Now the federal government is getting into the act. When will it ever end?!
On May 25, 2007, President Bush signed into law The Small Business and Work Opportunity Act of 2007 (“SBWOA”). Among the provisions is a change to the “kiddie tax” that makes custodial accounts (i.e. UTMA/UGMA) less palatable from an income and capital gains tax standpoint. More so, it destroys a popular college savings strategy making UTMA/UGMA accounts even less favorable when compared to §529 accounts.
Prior to 1986, intergenerational tax planning included re-titling assets into a child’s name to qualify for a lower tax rate on unearned income. Legislation enacted under the Regan administration brought about the kiddie tax where a portion of the child’s income was excluded, another portion was taxed at the child’s tax rate and, above that, all income was taxed at the parent’s highest marginal tax rate.
Small changes have been made to the kiddie tax through the years. Prior to 2006, it only applied to children under age 14. In 2006 it was made applicable to all children under age 18. Under SBWOA, the kiddie tax (beginning in 2008) will apply to children who are age 18 at the end of the tax year. Looking at this another way, the first year in which the kiddie tax may not apply is the year in which the child attains the age of 19.
Under current law, the first $850 of a child’s unearned income is tax free. The next $850 is assessed at the child’s tax rate. Anything above $1,700 is taxed at the parent’s highest marginal rate. Due to SBWOA, the kiddie tax will continue to apply even after a child attains the age of 19 if…
- the child is a full-time student
- the child does not attain the age of 24 by the end of the year
- the child’s earned income does not exceed 50% of his/her support
- the child’s unearned income exceeds $1,700
- the child has at least one parent living at the close of the tax year
- the child does not file a joint tax return (applicable only if he/she is
The impact of the new legislation is far reaching. The strategy of selling UTMA/UGMA assets once the child turns 18, paying the lower tax rate and using the funds for college is no longer valid. The kiddie tax will still apply. The preferred strategy, more than ever, is to use a §529 because its earnings are not subject to tax if distributions are used for qualified higher education expenses.