For many years, a so-called “kiddie tax” applied to the unearned income (dividends, interest, and capital gains, for example) of children who were age 13 or younger. The new law raises the age limit to age 17.

What’s more, the expansion of the kiddie tax rules is retroactive, so it covers the full year of 2006.

In essence, the kiddie tax has the following effects on the investment income of youngsters:

• A certain amount is tax-free. For 2006, the ceiling is $850.
• An equivalent amount is taxed at the lowest federal income tax rate. For 2006, a child’s next $850 of investment income will b taxed at a rate from 5% to 10%, depending on the type of investment income.
• The $850 limits will increase periodically, to keep up with inflation.
• Above the limits, investment income is taxed at the parents’ income tax rate, which generally will be higher.

A shift on income-shifting

The new kiddie tax rules affect income-shifting strategies. Previously, children age 14 and older were taxed as adults. They could have taxable income up to $30,650 (in 2006) that would be taxed at a rate no higher than 15%.

Therefore, it often made sense to transfer investment assets to children age 14 or older, to use their lower tax rates. Appreciated assets could be transferred to these children, who probably would owe no tax on a sale.

Now, the income-shifting won’t work until children reach age 18.

Strategies to consider

If you have children who will be younger than age 18 at year-end 2006 try to keep their investment income below $1,700 for the year. Up to that amount, the children will benefit from low tax rates, but higher income will be taxed at your rate.

A number of problems might be avoided by changing investment strategies to emphasize capital gains or deferred income, rather than current income (realizing the income and paying the tax at age 18 when lower rates will likely apply). Assuming that you’re comfortable with the risks involved, you might move some money from youngsters’ bank accounts to U.S. Savings Bonds, no-dividend growth stocks, or tax-managed mutual funds. Such vehicles can generate little or no taxable current income.

If your children age 14 to 17 will be over the $1,700 limit for the year (or if they’re already over the limit), you may pay higher-than expected income tax in 2006. In such situations, check with your CPA about increasing your estimated tax payments on September 15 and next January 15 to avoid penalties for underpayment of estimated tax.

On the other hand, you don’t have to wait until your kids reach age 18 to transfer appreciated assets to them, in anticipation of future sales. The sooner you begin the more assets you’ll be able to transfer to your children under the annual gift tax exclusion, now set at $12,000 per recipient per year.

Early Birds

As an example, suppose George and Grace Smith have two children, ages 12 and 15. The Smiths expect to eventually sell appreciated stocks and mutual funds to help pay for college.

This year, the Smiths can transfer up to $48,000 worth of securities to their children, tax-free: each spouse can give each child $12,000. Similar transfers can occur in subsequent years.

Once the children reach the year in which they’ll turn 18, they can begin to sell the (hopefully still) appreciated securities. As long as the children stay in the lowest two federal tax brackets, they’ll owe relatively little tax on such sales.