A key advantage that parents have when they save for college is that the number of tax incentives available to help them out. Paying less in taxes could make a big difference over time ($5,000 earning 5% per year tax-free for 18 years will turn into $ 12,033. $5,000 earning 5% per year but paying 15% capital gains or dividend taxes each year would turn into $ 10,576 - a meaningful difference). This benefit has encouraged parents to pick strategies like UGMA/UTMA accounts that help ensure that their investment income was taxed at their child's tax rate, rather than the parents.
This practice isn't as popular anymore, in part because of the availability of tax advantages vehicles such as 529 Plans and Coverdell accounts, and because of the IRS's introduction of the "Kiddie Tax". Instead of letting any amount of income be taxed at the child's rate (often zero, otherwise close to it), the Kiddie Tax rules require some of the income to be taxed at a higher rate.
How the Kiddie Tax affects 2009 Taxes
The Kiddie Tax rules have changed over time. The income cutoff, tax rate, and the age of children affected by the rule have all shifted.
The original Kiddie Tax rules affected children under 14 years old; their unearned income was taxed at a higher rate. The 2006 Kiddie Tax extended the age from 14 to 18—anyone under 18 with more than $1,700 per year in unearned income would be taxed at the parent's rate. (Income below that amount would still be taxed at the child's rate).
The current Kiddie Tax affects children under 19, and dependent full-time students under 24. The current cutoff is $1,900, so income below that amount is still taxed at the child's level.
A Kiddie Tax Exemption? Not Quite, But...
If you're worried about the Kiddie Tax affecting other parts of your child's life—like part-time jobs or internships—you may not need to be too concerned. The Kiddie Tax applies to "unearned income" including capital gains, interest, and dividends, not to paychecks.
In the past, one way to reduce the impact of the Kiddie Tax was to invest in assets that provided very little current income, such as low-dividend stocks and Series EE treasury bonds. As the age cutoff of the Kiddie Tax increases, these strategies may pay off less.
Not all parents who help their kids save for college will be affected by the Kiddie Tax, but it's important to factor it into your plans. If you're concerned about the Kiddie Tax, one way to potentially help minimize its impact is to consider a Custodial 529 Plan. However, there may be tax implications and you should consult with a financial advisor and tax consultant before making investment decisions.
The information provided is for informational purposes only and should not be relied on as tax or legal advice. Please discuss you particular situation with your tax advisor.
Investments in 529 college savings plans are neither FDIC insured nor guaranteed and may lose value. Please note the plan's disclosure document includes details such as investment objectives, risks, charges and expenses, and other information that you should read and consider carefully before investing. Plan disclosure documents can be obtained directly from the plan. Investors should consider before investing whether their or their designated beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's qualified tuition program and should consult their tax advisor.