College: How to Pay the Tax-Favored Way

Karen Hube:

ENDLESS CHILDHOOD ISN'T GOOD for the psyche -- or parents' pocketbooks. For the second time in two years, the "kiddie tax," which subjects a portion of children's investment income to their parents' rates, has been expanded; it now applies to offspring as old as 23.

The change first goes into effect for 2008 tax returns, so families should vet adaptive strategies now. The greatest impact likely will be felt by wealthy families who've transferred assets into their children's names to take advantage of their kids' lower tax brackets. But many will get hit simply because they saved diligently in their children's names for college, says Ed Slott, a tax adviser in Rockville Centre, N.Y.

The kiddie tax doesn't apply to 529 plans -- tax-free investment accounts earmarked for college savings. But it does apply to custodial accounts, which many set up in their children's names as college-savings vehicles before 529 plans' creation in the mid-1990s.

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%.

More on college expense tax credits here.

Posted by Jim Zellmer at February 10, 2008 3:01 AM
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