Kiddie Tax

A few years back, children were one of the best tax shelters going. Kids usually have a lower marginal tax rate than their parents, so it paid to put assets in the their names.

Congress put an end to that strategy by enacting the so-called "kiddie tax", which causes a child's investment income above a base amount ($1,700, in 2006) to be taxed at their parent's marginal rate. Simply put, if the child is in the 10% tax bracket and Mom and Dad are in the 28% tax bracket, the child's excess investment income can be taxed at 28%, rather than 10%.

The kiddie tax applies to any child who is under age 18 as of January 1, 2007 and has more than $1,700 of investment income. There are two ways to report the kiddie tax: on the child's tax return or on the parent's tax return.

Reporting your child's investment income on your own tax return is more convenient than filing a separate tax return for your child, but to report the income on your own return all these conditions must be met:

• The child's investment income consists of solely interest and dividends.
• The child's income has to be more then $850 and less than $8,500.
• The child did not make estimated tax payments or have tax withheld.

You must also meet one of these tests:

• You are filing a joint return for 2006 with the child's other parent.
• You and the child's other parent were married to each other but file separate returns for 2006 AND you had the higher taxable income. If you do not know if you had the higher taxable income, see Pub. 929.
• You were unmarried, treated as unmarried for Federal income tax purposes, or separated from the child's other parent by a divorce or separate maintenance decree. You must have had custody of your child for most of the year (you were the custodial parent). If you were the custodial parent and you remarried, you may make the election on a joint return with your new spouse. But if you and your new spouse do not file a joint return, you qualify to make the election only if you had higher taxable income than your new spouse. If you and the child's other parent were not married but lived together during the year with the child, you qualify to make the election only if you are the parent with the higher taxable income.

To report your child's investment income on your return, use Form 8814 or our Interview topic, Child's Income on Your Return. Bear in mind that the choice can result in a higher tax burden for the family than would filing a separate return for the child. Raising your income can reduce tax breaks such as itemized deductions and some credits, and may raise your state taxes, too.

Since you're using TaxCut, it makes sense to have the program prepare a separate return for your child. To report your child's investment income on his or her own return, begin a new return for your child. Our Interview will help you through the process, including figuring the kiddie tax on the child's Form 8615.