Finally setting up a college savings fund for your little one, huh? Then you've got to decide whether to put the account in her name, or in yours. And before you make that decision, you'll need to know the lowdown on the "kiddie" tax.
This meddlesome tax (but which ones aren't, right?) was established in 1986 to catch rich parents who were trying to circumvent taxes on their investments by putting the investment assets in the names of their little children. The tax applies only to children under the age of 14 as of Dec. 31 of the year in question. (After that, a child is taxed just like an adult.)
The kiddie tax rules allow a child under 14 to receive $750 in 2003 in investment income (from interest, dividends or capital gains) free of tax. The next $750 is taxed at the child's rate — presumably 10% or 15% for income and short-term capital gains, and 10% for long-term capital gains. Anything after that is taxed at the parents' rates, which can be as high as 38.6% for 2003. That means that $504 is the most you can save in 2003 taxes when the kiddie tax applies to your child's investment income.
Here's what you give up for that savings. First, you lose control of the money once your child turns age 18 or 21, depending on your state. "If your kid decides he wants to skip college and ride a Harley around Europe for a year, he can take that money and go," warns Joan Chasen, a Framingham, Mass.-based fee-only financial planner. Second, you may be reducing your child's chances of getting financial aid. Here's why: Colleges will expect a child to contribute 35% of the assets in his or her own name to cover college expenses while parents are expected to contribute only 5.6% of theirs.
But for some parents there is a big tax advantage that may balance the drawbacks listed above: If you are bumping up against the threshold to qualify for Roth IRA and Education IRA accounts (now called Coverdell Education Savings Accounts), which are limited to certain adjusted gross incomes, you can increase your chances of qualifying by moving income to your children . "Every dollar you keep out of your adjusted income helps in terms of the myriad phaseouts in the tax code," explains David Foster, a fee-only financial planner in Cincinnati. "If you take $50,000 and put it in your kid's name, you may have removed $5,000 [of investment earnings] from your 1040 and kept AGI under $150,000." Thus, you would just meet the cutoff for opening a Roth.
Once you decide to put assets in your child's name, there are a couple ways to minimize your exposure to the kiddie tax. One is to buy tax-exempt bonds or series EE or Series I U.S. savings bonds, the interest of which isn't taxed until maturity or redemption. You can wait until the kids have grown out of the kiddie tax to cash them in, and avoid the issue altogether. Or, if the interest on bonds is less than $750 annually, you can report that income every year and pay nothing. Then, when the bonds mature, you'll pay no taxes on them. But these investments won't provide the kind of capital appreciation you probably want in a college-savings account.
If that's the case, go for stock or equity mutual funds instead. For example, you can minimize your tax bill by buying index funds, which sell stocks infrequently and thus generate few taxable gains. There are also funds specifically designed to minimize taxable gains and income by carefully selecting shares to sell so that capital losses offset capital gains or low-dividend stocks with the potential for lots of capital appreciation. You can then sell your child's stock or mutual fund shares after he or she is 14. At that point, the kiddie tax rules won't spoil the tax savings.
