Parents and grandparents have long given securities to youngsters so that the income from those investments is taxed at the children's lower rate.
Last year, Congress tried to rein in this practice by raising the age of children subject to the so-called "kiddie tax." Basically, once a child's investment income reaches a certain point, the child pays taxes based on the parent's higher tax rate.
But apparently the loophole wasn't closed tightly enough. Tucked into the bill that includes funding for the Iraq war and an increase in the minimum wage was a provision to again raise the age limit for the kiddie tax. Beginning next year, even college students in their early 20s might find themselves subject to a kid's tax.
"It's one of those sneaky little things the government likes to do so they can say they didn't raise taxes, but they did raise revenue," says John Bacci, a Linthicum financial planner. "I would view it as a tax increase."
For much of its 20-year history, the kiddie tax applied to those under age 14. Congress increased the age limit last year so the tax now applies to those under 18.
The kiddie tax kicks in once a child's unearned income exceeds a certain amount - $1,700 this year.
Unearned income is typically interest, dividends and capital gains, but not wages from a child's job.
This year, the first $850 of unearned income is not taxed; the next $850 is taxed at the child's rate. Income above $1,700 is taxed at the parent's presumably higher rate.
Beginning next year, the kiddie tax will expand its reach to include those who are 18. It also will apply to full-time students who are older than 18 but younger than 24 and can be claimed as dependents by their parents. Young adults who provide more than half of their financial support aren't subject to the kiddie tax.
This change comes into effect just when long-term capital gains taxes for low-income investors are about to go away.
Right now, the tax rate for long-term capital gains and certain dividends is 5 percent for those in the two lowest tax brackets, compared with 15 percent for everyone else. Next year, those taxes will disappear altogether in the lowest brackets. This stays in effect through 2010.
Families who had transferred investments to children in anticipation of escaping taxes will find their plans stymied.
"This change really does close down the opportunity for a child to qualify for that zero percent rate in 2008," says Bob D. Scharin, a senior tax analyst with Thomson Tax & Accounting in New York.
You don't have to be wealthy to feel the impact of the kiddie tax changes. Older teens who had been receiving a few thousand dollars a year from relatives to invest for college might be selling those stocks or mutual funds in the next year or so for college, Scharin says. "If they had stock for 10 years, they could be recognizing a lot of gains," he says.
Raising the kiddie-tax age is expected to bring in $1.43 billion in revenue over the next decade, according to the Joint Committee on Taxation.
If you have been shifting investments to children, review your strategy before the kiddie tax changes.
Teens who are too old for the kiddie tax this year might want to sell their investments now, Scharin says.
"If a child happens to be 18 this year or 19, that child might as well sell the assets in 2007 and get the gain subject to a 5 percent tax rather than wait until next year" when the parent's higher rate would apply, Scharin says.
Families also might want to look at other investments that are tax friendly but not likely to get entangled with the kiddie tax, such as a 529 college savings plan.
With this plan, parents can invest for their children and not pay any taxes on the gains provided the money is used for college. Many states that sponsor 529 plans, including Maryland, offer a tax deduction to residents contributing to their home state plan.
The catch: If 529 money isn't used for college, withdrawals are taxed as ordinary income and subject to a 10 percent penalty.
Tom Kelley, a senior financial planner at Wilmington Trust in Baltimore, says parents also might consider investments for children that will appreciate in value but generate little taxable income. That includes land, growth stocks that pay few if any dividends and municipal bonds.
U.S. savings bonds, too, could appeal to young investors because they won't pay taxes on the accruing interest until they sell the bonds, Scharin says.
If children are earning money from a job, they will be eligible to contribute to a Roth IRA. Parents can help young workers fund a Roth. The maximum contribution this year is $4,000 or the child's annual earnings, whichever is less. Money goes into the Roth after taxes have been paid, but withdrawals in retirement are tax-free.
There's one other consequence to raising the kiddie tax age that might make parents uncomfortable, Scharin says. "In order to file their returns, the kids will need to know what the parent earns," he says.
Parents might not mind disclosing their salary to a 10-year-old who doesn't understand finances, Scharin says. But they might dislike sharing that information with a knowledgeable college student who could use it to argue that the family can afford, say, a new computer.
To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose@ baltsun.com.