Children, College, and the "Kiddie Tax"

Despite various crackdowns, income splitting can still save your family money. If you're planning to help pay for your children's college education, starting to give them the money for tuition long before the first bill comes due can still get Uncle Sam to help pay the bill.

Remember that the first $1,600 of unearned income escapes the kiddie tax in 2004. A child could have $40,000 in an account yielding 4 percent without having to worry about the kiddie tax. If that $1,600 is the child's only income in 2004, the tax bill will be just $80. If the same $1,600 were taxed in the parents' 35 percent bracket, for example, the tax would be $560. The $480 savings is the IRS contribution to the college fund.

Since the kiddie tax disappears when a child reaches age 14, consider giving your kids investments that defer income until that time.

U.S. savings bonds are a natural choice because income can be deferred until the bond is cashed. If that's after the child reaches 14, even the interest that accrued before age 14 is taxed at the child's own rate. However, it may be a better deal to buy the bonds in the parent's name rather than making the child the owner. When parents own the bonds and cash them in to pay a child's college tuition and fees, the interest on the bonds can be totally tax-free if the parents' income is below the limit for the year in which the bonds are cashed.

Growth stocks, which generally throw off little if any current income in the form of dividends, are another way around the kiddie tax. As the stock appreciates, there is no tax on that paper profit. If the stock is sold after the child is 14, the profit is taxed at the child's rate. Note that if a child invests in growth-stock mutual funds, rather than individual stocks, the fund will pay out capital-gain distributions each year based on gains recognized by the fund. Such income would be subject to the kiddie tax if the child's unearned income exceeds $1,600 (for 2004).

For income splitting to work, the child must actually own the assets that generate the income. If you want your son to pay taxes at his rate on $1,000 of interest income generated by a $25,000 savings account, you can't simply give him the $1,000. You've got to give him the $25,000 in the account. Only then will the income it produces be his for tax purposes.

The easiest way to make such a gift to a minor child is to set up a custodial account under your state's Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA). Banks, savings & loans, credit unions, mutual funds, and brokerage firms offer such accounts. All you need is a Social Security number for the child and a custodian to manage the account until the minor comes of age. You can name yourself custodian, but if you are also the donor and you die before the child reaches maturity, the gift will be considered part of your estate for federal estate-tax purposes.

An important point about custodial accounts is that your gift is irrevocable - you can't get it back. Once the child becomes an adult under your state's law - typically 18 or 21 - adult supervision of the account ends and the child can do anything he or she wants with the money. If sandy beaches are more enticing than ivy-covered walls - well ...

You don't need a custodial account if you invest the child's money in U.S. savings bonds. Just buy the bonds in the child's name. Don't name yourself co-owner, though, or the income will still be taxed to you when the bonds are cashed.

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