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How to Cut Down the Kiddie Tax

One of the basic tax strategies is to transfer income-producing assets (cash, stock or real estate, etc.) to the younger generation. Reason: The subsequent income is taxed to a child in his or her low tax bracket instead of your higher bracket.

However, you may have to pay a price for this income-shifting technique. If the so-called “kiddie tax” applies, some of the child's income will be taxed at a higher tax rate than the child's regular tax rate. This could defeat your original tax intentions.

Background: Normally, income is taxed at the tax rate of the person who receives it. However, unearned income received by a child under the age of 14 is taxable at the top marginal tax rate of the child's parents to the extent it exceeds an annual threshold. In other words, instead of being taxed at the low tax rate of 10%, the effective rate on the income may be as high as 35%.

The annual threshold is adjusted for inflation. For 2006, the limit is $1,700 (up from $1,600 for 2005). The first $850 is tax-free; the next $850 is taxed at 10% rate. Reminder: The tax only applies to unearned income (such as capital gains, dividends and interest). Any other income your child earns is exempt from the kiddie tax.

Keeping that in mind, here are some possible ways to reduce the impact of the kiddie tax.

*Monitor your child's investment income. If you are careful to stay below the $1,700 fault line, you will not have any kiddie-tax problems at tax return time. For instance, you might invest in CDs (certificates of deposit) that will not mature until 2007 on the child's behalf. This technique works especially well for children who are turning age 13 this year.

*Emphasize tax-deferred investments. Instead of investments that produce current income, shift more of your child's portfolio into long-range vehicles such as growth stock. Similarly, if you buy U.S. Savings Bonds in the child's name, he or she does not have to pay any current tax.

*Switch some investment dollars into municipal bonds. Generally, there are no federal tax consequences for investments in municipal bonds or municipal bond funds. Reason: The income received is exempt from federal income tax.

*Hire your child. Because the wages are earned income, the kiddie tax does not apply. Assuming that the child is paid a reasonable amount for the services actually performed, the business can deduct his or her salary. The Tax Court has even approved a work arrangement for a nine-year-old.

Despite recent tightening of the tax brackets, income-shifting still may be beneficial for affluent families. We can help you devise a plan for your personal circumstances.

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	[ return to list ] How to Cut Down the Kiddie Tax One of the basic tax strategies is to transfer income-producing assets (cash, stock or real estate, etc.) to the younger generation. Reason: The subsequent income is taxed to a child in his or her low tax bracket instead of your higher bracket. However, you may have to pay a price for this income-shifting technique. If the so-called “kiddie tax” applies, some of the child's income will be taxed at a higher tax rate than the child's regular tax rate. This could defeat your original tax intentions. Background: Normally, income is taxed at the tax rate of the person who receives it. However, unearned income received by a child under the age of 14 is taxable at the top marginal tax rate of the child's parents to the extent it exceeds an annual threshold. In other words, instead of being taxed at the low tax rate of 10%, the effective rate on the income may be as high as 35%. The annual threshold is adjusted for inflation. For 2006, the limit is $1,700 (up from $1,600 for 2005). The first $850 is tax-free; the next $850 is taxed at 10% rate. Reminder: The tax only applies to unearned income (such as capital gains, dividends and interest). Any other income your child earns is exempt from the kiddie tax. Keeping that in mind, here are some possible ways to reduce the impact of the kiddie tax. Monitor your child's investment income. If you are careful to stay below the $1,700 fault line, you will not have any kiddie-tax problems at tax return time. For instance, you might invest in CDs (certificates of deposit) that will not mature until 2007 on the child's behalf. This technique works especially well for children who are turning age 13 this year. Emphasize tax-deferred investments. Instead of investments that produce current income, shift more of your child's portfolio into long-range vehicles such as growth stock. Similarly, if you buy U.S. Savings Bonds in the child's name, he or she does not have to pay any current tax. Switch some investment dollars into municipal bonds. Generally, there are no federal tax consequences for investments in municipal bonds or municipal bond funds. Reason: The income received is exempt from federal income tax. Hire your child. Because the wages are earned income, the kiddie tax does not apply. Assuming that the child is paid a reasonable amount for the services actually performed, the business can deduct his or her salary. The Tax Court has even approved a work arrangement for a nine-year-old. Despite recent tightening of the tax brackets, income-shifting still may be beneficial for affluent families. We can help you devise a plan for your personal circumstances. [ return to list ]
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