In the past couple of years, Congress has been tinkering with the Kiddie
Tax rules. Beginning in 2006, they raised the age of children who are
subject to the Kiddie Tax from under the age of 14 to under the age of 18. Now, another law change raises the age again, beginning with tax year
2008. The effect of these recent changes will be increased taxes for
many middle-income and wealthy families who thought they were planning
prudently for financing their children’s college education.

The purpose of the Kiddie Tax is to keep parents from placing investments
in a child’s name to take advantage of the child’s lower tax rates. Thus,
under the Kiddie Tax rules, a child’s investment (unearned) income in
excess of an inflation-adjusted amount is taxed at the parent’s top tax rate, while the child’s earned income, such as wages, is taxed at the child’s own marginal tax rate.

To avoid the negative effects of the Kiddie Tax, it has been a popular
higher-education funding tax strategy for parents to transfer appreciated capital assets, such as stock, to a child to be sold after the child was out
from under the Kiddie Tax rules – initially age 14, then age 18 after the 2006 rules change. This strategy looked to be especially attractive for years 2008 through 2010 when the tax rate for long-term capital gains (and qualified dividends) drops to zero for taxpayers in the 15% or lower marginal rate. Parents of unmarried children, age 18 to 23, who are full-time students, expected that the children would also be able to enjoy the lower capital
gains rates.

However, Congress has essentially closed this loophole by subjecting
children through age 18 and full-time students, age 19 to 23, to the Kiddie
Tax rules, beginning in 2008. Another change to the rules may prevent
some of these older children from falling into the Kiddie Tax trap; if the child’s earned income exceeds one-half of the child’s support, the Kiddie Tax rules won’t apply. Support includes items such as clothing, education (but not scholarships), food, transportation and lodging. Because of these impending changes, a parent may want to reconsider any planned transfers of income-generating stocks, bonds, and other investments to children age 18, or those age 19-23 who are full-time students. However, placing or moving a child's funds into investments that produce little or no current taxable income can
help avoid the Kiddie Tax, at least in the years until the investments need to
be sold or redeemed to pay for the education expenses. These investments include:

• U.S savings bonds – Interest can be deferred until the bonds are cashed.
  
  
• Tax-deferred annuities – Interest can be deferred until the annuity is surrendered.
  
  
• Municipal bonds – Generally produce tax-free interest income (may be taxable to the state).
  
  
• Growth stocks – Stocks that focus more on capital appreciation than current income.
  
  
• Unimproved real estate – That provides appreciation without current income.

If the family has a business, that family business could employ the child. The child’s earned income is not subject to the Kiddie Tax and will generate a deduction for the family business (assuming the wages are reasonable for work actually performed). The child’s earned income can offset the standard deduction for a dependent and the excess income will be taxed at the child’s rate (not the parent’s). In addition, the child would also qualify for an IRA, which provides additional income shelter.