Congress Closes 'Kiddie Tax' Loophole

A new law targets parents who gift assets to their children in order to avoid a higher tax bite.
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Consider this another step in the "tax accountants full employment act": The latest change in the tax law applies the "Kiddie Tax" to much older kids! The change targets wealthy parents who gift assets to their children to avoid paying their own, higher tax rate.

Until 2005, the tax on a child's unearned income, such as dividends, interest and capital gains, was paid at the parents' marginal rate if the child was under age 14. Last year, the age limit was raised, requiring children under age 18 to be taxed at the parents' rate. Now, starting in tax year 2008, the age limit will apply to children under age 19 -- or to "kiddies" who are full-time students under the age of 24.

Of course, the kiddie tax only applies to unearned income in excess of $1,700. The first $850 is tax free and the next $850 is still taxed at the child's rate.

(Note: This rule does not apply to "earned income" such as from a summer job, or even to a baby who earns modeling fees. That earned income can still be reported on a child's separate return and taxed at the child's lower rate.)

Capital Gains Loophole Closed

The ability to gift appreciated stock to children who would pay lower tax rates was considered a "loophole." By closing that opportunity, the government expects to collect as much as $1.5 billion in extra tax revenues over the next 10 years.

This "loophole" has been a particularly enticing opportunity in recent years because of capital gains rates that have been dropping for those in the lowest two brackets, between 10% and 15%.

The maximum capital gains tax rate on assets held for at least one year, and sold for a profit, is 15% -- no matter what your ordinary income tax bracket (with a few exceptions for collectibles and some other assets). But for those in the lowest two brackets, for tax year 2007, the maximum tax on capital gains is only 5%.

(For 2007, on an individual return, that 10% bracket applies to those who have taxable income of less than $7,825. The 15% tax bracket tops out at taxable income of $31,850.)

In 2008, it would have been an even better deal, because next year the capital gains tax rates will drop to zero -- yes, you read correctly, 0% -- for those in the lowest two tax brackets!

This zero rate will be particularly helpful to low-income senior citizens who may have to sell long-held stocks to pay living expenses. Now parents who want to transfer appreciated stocks to low-income kids -- who would be able to cash in at the lowest or zero capital gains rates -- will find themselves locked out of this deal.

Kids in High Brackets

Bye, bye tax loophole. Starting in tax year 2008, those kiddies under 19, or still in school, can file their own return but will still have to pay tax on unearned income at their parents' rate.

Mark Luscombe, principal tax analyst at CCH, says there are a few exceptions: "These kiddie tax rules do not apply to a child who is married and files a joint return. And a new rule says the kiddie tax does not apply if the child's own earned income provides more than one-half of their support."

But Luscombe goes on to point out: "This has really frustrated efforts to transfer assets to children to fund college tuition expenses. But it is still useful for parents who want to transfer assets that their children can hold until the first year after graduation -- before they are earning a big salary. Then the grad can sell at his own lower tax rate -- and use the proceeds to pay off student loans!"

As long as there is a Congress, there will be new tax rules. And there will be accountants to figure out a way around them. Surely, we could put all this expensive talent to better use! The flat tax or national sales tax look more appealing every day. And that's The Savage Truth.

   Terry Savage is an expert on personal finance and also appears as a commentator on national television on issues related to investing and the financial markets. Savage's personal finance column in the Chicago Sun-Times is nationally syndicated, and she released her fourth book,

The Savage Number: How Much Money Do You Need?

in June 2005. Savage was the first woman trader on the Chicago Board Options Exchange and is a registered investment adviser for stocks and futures. A Phi Beta Kappa graduate of the University of Michigan, Savage currently serves as a director of the Chicago Mercantile Exchange Corp. She also has served on the boards of McDonald?s and Pennzoil.