Guess My Favorite Tax Rate

Parents and grandparents old enough to remember when capital gains were taxed at twenty or twenty-five percent should be happy to pay fifteen percent, right?

Wrong!

Compared with zero, a fifteen percent tax bite causes real pain.

And zero is what the federal income tax on long-term gains will be next year, but only for lower-income taxpayers. Before a new tax law expanded the kiddie tax, this Wall Steet Journal article (subscription) reports, that gave some financial advisers a bright idea:

Anticipating this change, some investment advisers had been suggesting that high-income family members consider making gifts of securities that have gone up in value over the years to low-income family members, who could then sell those securities, tax-free, next year. The new law doesn't affect transfers to elderly parents or other relatives.

Typically, such transfers have involved moving appreciated securities to the low tax brackets of college age children who were beyond the range of the kiddie tax. Even this year's five-percent tax rate on capital gain, for low-bracket taxpayers, is less painful than fifteen percent.

But starting next year, most children in college will still be kiddies for tax purposes:

Under current law, investment income above a certain level (generally $1,700 for 2007) for a child 17 years old or younger typically is subject to the parents' tax rates, assuming the parents' rates are higher than the child's. That is still the law for this year. (Before the law was changed last year, the kiddie tax applied only to children younger than 14.)

Under the new law, the age limit will increase starting next year to children who are 18, or under 24 if the child is a full-time student. This expanded provision won't apply to some children with paid jobs. A congressional summary says the expanded provision applies "only to children whose earned income does not exceed one-half of the amount of their support." Even so, this new law "is going to affect a lot of people," warns Ed Slott, a New York CPA.

Trust fund babies need to watch out, the Journal article warns: "Income generated by a trust for which a child is the beneficiary may be subject to the kiddie tax, depending on how the trust was set up."