Act now to avoid stricter 'kiddie tax' rules next year

If you're looking to trim taxes on your investment earnings by giving assets to your children, you'd better act fast.

Next year, an expanded "kiddie tax" — which taxes a child's investment income above a certain level at the parent's higher rate — will affect older offspring.

In 2007, the kiddie tax applies to children younger than 18 whose investment income exceeds $1,700. (The first $850 of a child's unearned income is tax-free, and the next $850 is taxed at the child's lower rate).

Starting in 2008, children under 19 and full-time students under 24 will also be subject to the kiddie tax. (Children who provide more than half of their own support are not affected by the change). The first $900 of a child's unearned income will be tax-free, and the child's lower rate applies to the next $900.

What does this change mean to you? If you have children between the ages of 18 and 23, they aren't affected by the kiddie tax this year, but they will be in 2008. In 2007, they can still take advantage of the 5 percent rate on long-term capital gains that's available to taxpayers in the two lowest tax brackets, says Anne-Marie Fisher, director of tax services for CBIZ Accounting in Chicago.

Higher-income taxpayers pay a maximum capital-gains tax of 15 percent on qualified dividends and profits on investments held for one year or longer.

Megan Hakala, 19, falls into the kiddie-tax sweet spot. Earlier this year, Megan's parents, Jack and Maggie, gave the college sophomore shares of Marriott stock with a market value of $24,000 — the maximum married couples can give to an individual without filing a federal gift-tax form.

Jack had acquired the stock at a discount when he worked for Marriott, and when you transfer a stock or other property, the recipient of the gift assumes your original cost basis and holding period. Megan will sell the stock this year and use the cash to pay her tuition at Michigan State University.

The income-shifting strategy will save the Hakalas at least $1,600 in capital-gains taxes in 2007. That assumes $16,000 in profit from the sale and a 10-percentage-point spread between Megan's 5 percent capital-gains rate and her parents' 15 percent rate.

The Hakalas also plan to transfer stock to their daughter Jillian, 16, who will be headed to college in two years. They'll have her sell just enough stock this year to keep her profit below $1,700 and hold the maximum tax to her 5 percent capital-gains rate. They also intend to fully fund a Michigan 529 college-savings plan. That will qualify them for a state-tax deduction of up to $10,000 for 2007.

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Mary Beth Franklin is a senior editor to Kiplinger's Personal Finance magazine. Send your questions and comments to moneypower@kiplinger.com.