Parents who open investment accounts for their kids may find these earnings produce a larger tax bill than they had expected. For 2005 returns, tax law allows children younger than 14 to receive as much as $800 in tax-free investment income. This means the child doesn't have to pay taxes on any interest, dividends or capital gains up to this amount.
When a child must file: If the youngster's investment income exceeds $800, then the Internal Revenue Service expects a tax return from the child. The taxes here are at the child's usually lower rate. And when an investment held by a child generates annual returns of more than $1,600, what is known as the "kiddie tax" takes effect. This tax was created in 1986 to keep parents from sheltering income by putting accounts in the names of their lower-taxed kids.
Under the kiddie tax, a part of the child's unearned income over $1,600 could be taxed at the parent's tax rate. This could be as high as 35 percent on 2005 returns, depending on the parents' income. Although the new lower capital gains tax rates mean Mom and Dad now face just a 15 percent tax on proceeds from assets held more than a year, many families still find it advantageous to shift the tax burden to the youngster.
Choosing whether child or parent files: To figure a child's tax in this case, you'll have to fill out Form 8615 and attach it to the youngster's federal income tax return. If you and your spouse file jointly, the IRS wants the name and Social Security number of the parent who is listed first on the return so that it can ensure your child's tax is figured at the rate applicable to your joint income.
If you are married, but file separately, the name and tax ID number of the parent with the higher taxable income must be entered on Form 8615. It gets more complicated for parents who are separated, unmarried, treated as unmarried for tax-filing purposes or remarried. Check the Form 8615 instructions for details if one of these situations applies to your family.
Some parents save their child from tax-filing duties by reporting the youngster's investment income on the adults' return. This is an option if a child's earnings are only from interest and dividends, including capital gain distributions, and are less than $8,000. In these cases, the child's investment income is detailed on Form 8814, Parents' Election to Report Child's Interest and Dividends, and included with the parents' tax return. This way, the child doesn't have to file a return or Form 8615.
Child's income could cost parents tax breaks: Keep in mind, however, that when a parent adds a child's income to the adult's return, that extra money could mean the loss (or at least reduced benefit) of some tax deductions and credits that are phased out as income grows. You should run the numbers on both Form 8615 and Form 8814 to guarantee that you, and your child, pay the least possible tax on the youngster's investment earnings. If you have more than one child with unearned income, you must repeat this process for each youngster.
And remember, these tax rules apply only to investment income received by children who are younger than 14 at the end of the tax year. (For kiddie tax age purposes, the IRS considers a child born on Jan. 1, 1992, to be 14 years old at the end of 2005. That prevents the youngster's investment income from being taxed at his or her parents' higher rate.) Wages and other earned income received by a child of any age are taxed at the child's normal rate. More details on filing requirements for children can be found in IRS Publication 929, Tax Rules for Children and Dependents
