Not so long ago, families had a golden opportunity to save on income taxes by spreading the wealth among family members. Such "income splitting" was at the heart of many college savings plans and is most easily explained with an example.
Assume you have $50,000 to invest and can buy bonds yielding 5% to produce $2,500 income a year. Back in the old days, if you were in the 50% tax bracket the IRS would claim $1,250. However, if you transferred ownership of the bonds to your son or daughter—either with an outright gift or in a trust—that $2,500 of annual income would have been taxed to him or her. The tax bill could have been as low as $156. The family saved $1,094. Multiplied over a number of years, the tax savings delivered by income splitting could make a significant dent in tuition bills.
Congress has trimmed the tax-saving potential of income splitting by denying children the right to claim their own personal exemption. The inability to shelter income with the exemption translates to a higher tax bill. And Congress took direct aim at income splitting by creating a set of rules immediately dubbed the "kiddie tax." Basically, investment income earned by a child under 14 can be taxed in his or her parents' tax bracket, and as of 2006 it is a child under age 18.
There's a special form—Form 8615—for figuring the kiddie tax. It must be filed with the return of each of the half a million or so "kiddies" to whom the rules apply. Although children's returns once were among the easiest to complete, those that involve the kiddie tax are now among the most difficult. When developing the Form 8615, the IRS estimated that completing the single-page form would add nearly a full hour to the return-preparation chore. Fortunately, with TaxCut, it won't take you nearly as long.
If your son or daughter has earnings from a job, that earned income is always taxed in the child's bracket. Salary, tips and self-employment income are examples of earned income. Almost all other kinds of income—including interest, dividends, capital gains, rents, and trust income—fall in the unearned income category and are vulnerable to the kiddie tax. The distinction between earned and unearned income turns on whether the income is compensation for work performed.
Not all of a child's unearned income is covered. On 2006 returns, only investment income over $1,700 can be taxed in the parents' bracket. The first $850 is tax-free, because up to $850 of a child's standard deduction can be used to shelter unearned income. The next $850 is taxed at the child's rate, probably 10% or 15%, unless long-term capital gains are involved, in which case a 5% rate might apply. Excess unearned income is nicked by the parents' rate, as high as 35% for interest.
The kiddie tax disappears on the child's 18th birthday. If your child has his or her 18th birthday anytime during the year—even on New Year's Eve—the tougher taxing rules don't apply for any part of the year.
Note: You may be able to skip Form 8615. If your child's entire income is from interest and dividends, the total is less than $8,500, and the child is under age 18 at the end of the year, parents may simply report a child's unearned income on the parent's return, avoiding the need for Form 8615... and letting the child escape filing a tax return altogether.
To use this streamlined method, you must file Form 8814 with your own return. The form makes it clear that you do not simply add all the child's unearned income to your own taxable income. For 2006, the first $850 of the child's income is tax-free and the next $850 is taxed at the child's rate. The rest is added to your income and taxed in your tax bracket.
There are reasons to be leery of this shortcut, though. For one thing, reporting a child's income on your return will increase your AGI, and that could cost you tax-saving deductions. Medical and miscellaneous expenses are deductible only to the extent they exceed a certain percentage of AGI. The higher your AGI, the more of those expenses can not be deducted. The right to deduct IRA contributions is also tied to AGI. Restrictions on itemized deductions and exemptions are triggered by rising AGI, and, valuable child and college credits can also be lost as AGI rises. One more reason for not putting "kiddie income" on your return: doing so might result in a higher state tax bill for the family. Since you have TaxCut, let it prepare separate returns for your kids.