Kiddie tax

An article in this week's Baron's goes over kiddie tax changes for 2008. The basics from the story:

Under kiddie-tax rules, a child's unearned income of more than $1,800 (up from $1,700) is subject to the parents' tax rates of up to 35% on interest and short-term capital gains, and 15% on long-term capital gains and most dividends. The first $900 of the child's unearned income is tax-free; the second $900 is taxed at the child's rates. Most children are in the 10% or 15% income tax bracket, and they would typically be subject to the lowest capital-gains tax rate, which this year has dropped to 0%, from 5%.

Keep in mind this special tax treatment is for unearned income, not for earned income kids make by working. The real kicker is that the maximum age of children the kiddie tax applies to is rising to 18, or 23 for full-time, dependent students (it wouldn't apply to children not claimed as dependents on someone else's return). This will obviously effect your ability to lower capital gains taxes by gifting investments to children, and the article explains the ramifications.

I want to bring up one uncommon situation that I think makes this tax change really unfair. (Admittedly, it's far fetched). Let's say you are a full time student in college, under 24 years old, and you are a whiz at the stock market. All you do is pick winners. If you have capital gains of over $1800, and your parents have a higher tax bracket than you do, you'll pay taxes at a higher rate and are therefore penalized.

529 plans are not subject to the kiddie tax, and I'm using them to my advantage. Much more information on child tax rules are in IRS publication 929.