Grown-Up Headaches Can Spring From the IRS’ New ‘Kiddie Tax’ Rule
QUESTION: Is there any way around this “kiddie tax” hit that our family is about to take? Our 7-year-old son received about $5,000 last year from interest, dividends and the sale of some stock. His tax bill is in excess of $1,000 to the federal government alone! In the past, my wife and I have declared him as a dependent, but we are wondering about the wisdom of this, given his new tax status. Why couldn’t we drop him as a dependent and let him take his $1,950 personal exemption on his own tax return?--S. Q.
ANSWER: The reason is quite simple: The Internal Revenue Service thought of this first and made some initial moves to eliminate this possible loophole. According to our tax experts, the IRS hasn’t issued any explicit rules and regulations on the maneuver you are suggesting--yet. But many tax experts believe that the government made its intent clear when it said an individual eligible to be claimed as a dependent on another taxpayer’s return may not claim his own exemption.
Q: My husband and I need help. We are in our early 50s and earn a total of about $100,000 per year. We have at least $80,000 of equity in our home and another $35,000 in retirement accounts. Yet we couldn’t put our hands on $1,000 in cash without borrowing it. We have about $40,000 in consumer debt on which we pay interest ranging from 14% to 19.8%. Should we tap the equity in our home and pay off those bills? The monthly payments on these obligations leave us little room for anything but necessities. We are in the 33% tax bracket with no deductions except our mortgage interest.--L. O.
A: You have described your problem--and proposed solution--quite well. The financial planners we consulted agree that your idea to borrow against the equity in your house to pay off your consumer debt is a sound one.
Here’s a brief rundown of their reasoning: Given your age, and the fact that you have more than 10 years of full earning power ahead of you, a home equity loan makes perfect sense. The interest on the equity loan will be fully deductible and the rate is sure to be lower than the 14% to 19.8% that you are paying on your consumer debt. So you would be exchanging fully deductible debt payments for payments whose deductibility is gradually being phased out.
The bottom line is that you may well have more money on which to live if you refinance your debt as you propose. Of course, now it’s up to you to make sure that you don’t get into the same mess again. Remember, you can only spend your home equity once.
Q: Last week, you answered a letter from someone who has accumulated $265,000 in an individual retirement account. Can you explain to me by what financial legerdemain one can amass an IRA amounting to this large a figure? I did not think these accounts had been around long enough, nor permitted contributions large enough to accumulate such an amount.--B. B.
A: You are not alone. We heard from more than one reader about this seemingly huge IRA.
Although we can’t say for sure how this particular reader accumulated a $265,000 IRA, our best guess would be that he rolled over a lump-sum distribution from one or more pension plans into one or more IRA accounts. These moves are allowed by law and are considered one of the best ways workers can protect the tax-deferred status of their pension funds when they leave an employer.
Further, although you are probably well aware that Congress abolished the law that had allowed all workers to set aside $2,000 a year in an IRA on a tax-deferred basis, you may not know that you can still contribute to an IRA--just without most of the tax benefits. Workers who are covered by pension plans or do not meet the income limits for a tax-deferred IRA account may still make annual contributions of up to $2,000, or $2,250 if the worker’s spouse is not employed. These contributions are not tax-deferred. However, the interest generated in the IRA accounts is.
Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Please do not telephone. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.
