Taking the Bite Out of Kids’ Taxes

QUESTION: To help my children learn about business in general and the stock market in particular, several years ago my husband and I bought them several hundred shares of stock. They manage the portfolio, with a little input from us, and collect the dividends. All of the money is put away for their college education. In other words, I consider this whole process very educational and legitimate. So, I am extremely upset about the new tax law that forces youngsters’ earnings to be taxed at the parents’ tax rate instead of at the child’s lower rate. Is there any way to get an exemption if you can prove that the money is legitimately the child’s rather than the parents’?--P. L.

ANSWER: Sorry. Laws sometimes have to penalize those who abide by the rules to punish and stop those who don’t. That is the case here.

But there is a way to avoid the higher tax while continuing your children’s investment education. Simply swap their dividend-earning stocks for assets that don’t immediately produce taxable income. Stocks paying no dividends is one possibility. Savings bonds, tax-exempt securities or single-premium life insurance are other options.

None of these may measure up to the stock market right now--at least not in terms of immediate earning power. But when you throw the tax savings into the equation, you may find that one of these alternative investments--or a combination--is the better route to go. And the children would also learn about investments other than stocks.

You may reasonably ask next whether you wouldn’t just be delaying the inevitable. Such investments as savings bonds are, after all, eventually taxable. True, except that the point of this exercise is to try to delay the tax bill until your children are at least 14 years old. At that point, they are no longer subject to their parents’ tax rate--regardless of the size of their unearned income.

Say you decide to switch to EE savings bonds. These bonds don’t mature fully for 10 years, and the interest they earn isn’t taxable until they are cashed or reach final maturity, whichever comes first. So, all your children must do to avoid your higher tax bracket is to keep the bonds for a while--at least until they turn 14.

The new law you so protest came to pass because too many parents were using their children as tax dodges--shifting their own income-producing assets to their children only to take advantage of the youngsters’ lower tax bracket. It was a mechanism that saved many taxpayers--principally high-income ones--thousands of dollars a year.

So when the lawmakers were reviewing the tax laws last year as part of Congress’ sweeping tax reform, they decided to lower the boom on children’s “unearned” income--that is, on such non-wage earnings as interest and dividend payments or distributions from a trust.

From this year on, Congress decided, a portion of the unearned income reported by children under age 14 must be taxed at the parents’ income tax rate.

As you may already know, the new law makes the first $500 of a child’s unearned income tax-free; the second $500 is taxed at the child’s tax rate. And any unearned income in excess of $1,000 will be taxed at the parents’ tax rate. Before, the first $1,000 in unearned income reported by a child was exempt from taxation and amounts over that were taxed at the child’s rate.

Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Los Angeles Times, 780 Third Ave., Suite 3801, New York, N.Y. 10017.