Congress has officially extended childhood to age 18 – at least for purposes of calculating tax on
investment income.

The “kiddie tax” specifies the age at which children become a separate tax entity from their parents for
purposes of calculating tax on investment income. From birth to age 14, children could earn investment
income up to two times the standard dependent deduction and be taxed at
their tax rate, typically 10 percent. Any investment income over that threshold
was taxed at the parents’ presumably higher tax rate. After 14, all investment
income was taxed at the child’s lower rate.

The Tax Increase Prevention and Reconciliation Act of 2005, passed by
Congress and signed by President Bush in May 2006, upped the age to 18.
A child is considered to be 18 for the entire tax year in which he or she turns
18. For 2006, the standard dependent reduction is $850, putting the
threshold for investment income at $1,700. That amount is taxed at the
child’s rate. Anything in excess of that amount is taxed at the parents’ rate.

The kiddie tax applies only to investment income, not earned income, so
teens with jobs pay income tax at their rate, not their parents’. Individuals
who marry before age 18 presumably aren’t children anymore, and if filing
jointly, file at their own rate.

The change puts the future of accounts established under Uniform Gifts to
Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) in
question. Under these acts, individuals can place assets in accounts for the
benefit of a child but retain control of the assets as the trustee  until the child
reached the age of majority, usually 18. The tax benefit of moving assets to
a child’s name may now be reduced, as income invested in these accounts
over $1,700 will be taxed at the parents’ rate anyway.

UGMA/UTMA assets can be transferred to a 529 College Savings Plan for
the same child, however. 529 accounts can receive only cash, so assets in
an UGMA/UTMA may have to be liquidated and any realized gain would be
subject to capital gains tax. Because UGMA/UTMA assets belong
specifically to the child and 529 funds can be transferred to other family
members, the account must be segmented. UGMA/UTMA assets within a
529 plan are not considered the property of the child for financial aid
calculation.

With a capital gains rate of just 5% for kids in the 10% or 15% tax bracket, parents in higher brackets
may still want to consider transferring appreciating assets. But parents who thought they had the years
between 14 and 18 to sell assets in their child’s portfolio and potentially pay no capital gains tax have
lost that option. Still, college students most often fall in a lower tax bracket than their parents, so selling
after the child turns 18 will most likely mean less capital gains than if the parents had sold those assets.

This article was submitted by Robert Valentine of Financial and Retirement Management.Robert Valentine is a well-known expert in the matters concerning investors. His articles on financial planning matters that concern investors have been published by several publications throughout the United States.