New Law May Give Teens -- and Their Parents -- a Tax Headache
In its latest search for sources of tax revenue, the federal government has targeted an unlikely group: teenagers.
The Tax Increase Prevention and Reconciliation Act, signed into law in May, aims to raise $2.1 billion over the next 10 years with a change in the so-called kiddie tax.
The change is a relatively simple one, noted Mark Luscombe, principal tax analyst with CCH Inc. It broadens the pool of youths who could be subject to this tax by raising the cutoff age to 18 from 14, retroactive to the beginning of 2006.
It sounds innocuous enough, but tax experts say it lets loose a flood of complexities.
“It’s an accounting nightmare,” said Patty O’Connell, a partner at the Santa Monica tax law and accounting firm Hothouse Carlin & Van Trigt.
Here are some questions and answers to help you understand how the law will work.
Question: What is the kiddie tax?
Answer: The kiddie tax, first implemented in 1987, was designed to stop wealthy parents from shifting significant amounts of income-earning assets to their children to get the benefit of the child’s lower marginal tax rates.
In a nutshell, the law says that unearned income -- that’s income from savings or investments -- claimed by a child younger than 18 is subject to tax at the parent’s rates, once the income exceeds a certain threshold. That threshold changes each year with inflation; it is currently $1,700.
Q: Why is the age cutoff of 18 significant?
A: Mainly because the tax starts getting complicated when the child has more than one type of income. With children under 14, that’s rare. But it is common for 16- and 17-year-olds also to earn wage income. And that’s when it gets tricky.
If the child has only interest or investment income, the child can report it on his or her parents’ return by filling out the nine-line Form 8814.
That form allows a standard deduction of $850, which makes the first $850 in investment income tax free, with the next $850 taxed at the child’s rate. Any amount over $1,700 is taxed at the parents’ rate. And because this is done on the parents’ return, that rate is no mystery.
A child with wages and withholding must fill out his or her own tax return. If the child had no investment income, this would be a snap, because he or she could use the 12-line 1040EZ.
But if the child has wages and investment income sufficient to trigger the kiddie tax, he or she can’t use the 1040EZ. Now the simplest form allowed is the 48-line 1040A. What’s more, the standard deduction is no longer $850. It’s $300 plus earned income, up to a total of $5,150, Luscombe said.
The tax rate on the investment income will depend on whether the income comes from capital gains, dividends or interest and whether the child is taxed at his or her own rate or at the parents’ rate. If the parents are divorced, the child has another complication in figuring out which parent’s rate applies. And the child must complete the 16-line Form 8615, which asks for the parent’s tax information.
In other words, a 17-year-old with wages and sufficient investment income is facing a minimum of 66 lines’ worth of tax calculations.
“This is where we get hired,” said Jack Nuckolls, senior tax director at BDO Seidman in San Francisco. “Forget the additional tax. The real expense is that this kid may have to hire a CPA.”
Q: Is there any way to get around the kiddie tax?
A: People with young children can dodge it easily by putting the child’s college money in a 529 plan, which accumulates earnings tax free, O’Connell said. They can also invest in tax-free municipal bonds or growthoriented assets that appreciate but don’t pay significant dividends or interest that can be taxed.
However, for those with children who are already 14 or over, it may be too late to avoid the tax hit. Many parents, relying on the old law, may have set up college accounts for their offspring in so-called Uniform Gift to Minors Act accounts, Nuckolls said.
Income generated in these accounts is taxable when earned. Parents may have set it up so the bulk of this income would be received after the child turned 14, so they’d avoid kiddie taxes under the old rules. If so, they’ll get hit now -- and there’s little they can do about it.
“If you set things up to mature when the child was 14 or 15, you are going to get caught by this,” Nuckolls said.
He said he expected a lot of accountants to have some unhappy clients. “We’d just like to say, don’t kill the messenger.”
Kathy M. Kristof, author of “Investing 101” and “Taming the Tuition Tiger,” welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof @latimes.com. For previous columns, visit latimes.com/kristof.
