YOUR TAXES: A SPECIAL REPORT : KIDDIE TAX : IRS Isn’t Taking Candy From Babies, but It Is Requiring More of Them to File

It’s not as much fun to be a kid anymore.

As a result of tax law changes that take effect this year, many children--from toddlers to college students--will have to pay income taxes for the first time, and others will have to pay at higher rates than in the past.

Children with as little as $500 in investment income will have to file a tax return, no matter how young. In the past, a child could earn more than twice that amount without having to file a tax return.

Under the new rules, investment income over $1,000 is taxed at the parents’ rate for a child under age 14. The first $500 in investment income is tax free and the second $500 is taxed at the child’s rate.

For example, if a child received $3,000 in investment income, the first $500 would be tax exempt, the second $500 would be taxed at the child’s rate and the remaining $2,000 would be taxed at the parents’ higher rate.

Children who are 14 or older receive more favorable tax treatment. For them, the first $500 in investment income is tax free, and the rest is taxed at the child’s rate.

Congress enacted the so-called “kiddie tax” to discourage parents from shifting income-producing assets to their children, who were taxed at a lower rate. As a result of the tax law changes, much of a small child’s investment income is taxed at the parents’ higher rate.

However, the way earned income is taxed remains unchanged. As in the past, earned income is taxed at the child’s rate--normally, 11% on taxable income up to $1,800 and 15% on taxable income between $1,800 and $16,800. This year, up to $2,540 can be earned by the child tax free. That amount increases to $3,000 in 1988.

The new tax changes are expected to result in an additional 10 million tax returns from the nation’s youngest taxpayers. According to the new rules, children with investment income over $500, or earned income over $2,540, must file a tax return.

So far, the changes have resulted in “a lot of confusion,” said George McCrimlisk, a partner at Peat Marwick Main & Co.

McCrimlisk says many of the questions he receives concern how to handle taxes for children of divorced parents. He said that, in general, a child’s investment income is taxed at the rate of the custodial parent. In the cases of joint custody, the child’s investment income is taxed the same as the parent with the higher rate.

McCrimlisk says another source of confusion is the way the personal exemption has changed. Children who are claimed as dependents on their parents’ tax return lose their own $1,900 personal exemption. In the past, parents and children received the exemption.

Andy Harwood, a partner at Price Waterhouse & Co. in Los Angeles, says that parents who earn more than $149,250 lose the benefit of the personal exemption and may wish to let their child use it. However, to use the exemption, the child should have earned half the amount needed to support himself.

“For example, if you think it takes $5,000 to support a child for one year, the child better have earned income of $2,500,” Harwood explained.

Parents who earn less than $149,250 should claim their children as dependents and retain the personal exemption, Harwood said.

McCrimlisk said the tax reforms affect children such as child actors, who invest their wages in stocks and interest-bearing accounts. Though the child’s wages would be taxed at the child’s rate, the investment income would be taxed at the parents’ rate for children under age 14.

“The provisions of the law were designed to prevent income shifting, but it was written so broadly that all unearned income is taxed at the parents’ rate,” McCrimlisk says.

The tax revisions have dealt a death blow to Clifford trusts and other vehicles long used by upper-income families to save for a child’s education. The trusts were popular because a parent in a high tax bracket could put securities in a trust and have the income produced by the securities taxed at the child’s lower rate. After 10 years, the parents could reclaim the money, so there was no danger of the child using the money to buy a Porsche.

Congress removed the advantages of these trusts by making the income taxable at the parents’ rate. Trusts that were established before March 1, 1986, are exempt from the new rule, although income produced from the assets put into the trust after that date are now taxed at the parents’ rate.

Though the new rules make saving for a child’s education harder, there are still ways to save.

McCrimlisk recommends Series EE U.S. savings bonds. The interest income on the bonds isn’t taxed until they are cashed, so parents can buy the bonds for children who are under age 14 and hold them until the children turn 14. At that time, the interest income will be taxed at the child’s lower rate.

McCrimlisk says the savings bonds, as U.S. government securities, have the additional advantage of safety. Also, the interest paid on the bonds is automatically adjusted to keep pace with market rates, yet they can’t fall below 6%.

Other tax advisers suggest investing in a portfolio of growth stocks. Since the stocks don’t pay a dividend, taxes on the appreciation in the stock price are deferred until the stocks are sold. Parents who buy stocks for a child can sell the securities after the child turns 14, when the gains will be taxed at the child’s lower rate.

Unlike the savings bonds, a stock investment is risky. A plunge in stock prices--such as the crash last Oct. 19--can erode or even wipe out an investment. For this reason, most financial advisers recommend that parents chose a mutual fund with a good track record rather than try to pick the stocks themselves.

The new tax code also requires parents to get Social Security numbers for children age 5 or older to claim them as dependents on their income tax returns. Congress adopted this rule to cut down on the number of people who claimed deductions for non-existent children and to prevent divorced couples from claiming the same child on their separate tax returns.

Besides changing the way children are taxed, the reforms may also be changing the topics that families discuss. Since children are taxed at their parents’ rate, they may need to know how much their parents earn--if the children prepare their own returns. “This is not a technical issue but a communication issue,” Harwood says. “How much parents make is not a normal dinner table topic in most homes.”