Use of Educational Savings Accounts in Light of the Revised “Kiddie Tax”

Overview

The Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) further restricted the ability of parents to shift their income tax burden to their minor children so that such money would be taxed at the child’s lower rates. This shifting tax burden, known as the “Kiddie Tax”, previously only applied to minor children who had not reached the age of 14 by the end of the taxable year. Now, parents of children under the age of 18 will be taxed on the unearned income of their children.

Specific Application

In 2006, the unearned income of a minor, up to $850, is not taxed. Unearned income greater than $850 but less than $1,700 is taxed at the minor’s rate. However, a minor’s unearned income over $1,700 is taxed at the parent’s highest marginal rate, if application of that rate results in a higher tax than the minor would have otherwise paid as a single person. In certain circumstances, a parent may make a “pick up” election to include the minor’s gross income (in excess of $1,700) on the parent’s own return. The threshold of $1,700 will be indexed for inflation. The Kiddie Tax does NOT apply to qualified Disability Trusts.

Planning

As a result of this change in the law, parents and grandparents now have one more reason to set up a Coverdell Education Savings Account (CESA) or a Qualified Tuition Program (529 plan) as opposed to a custodial account to save for a child’s college education. Both the CESA and the 529 plan permit tax-free accumulation of the principal contributions and the ability to roll over the accounts to other children. Most importantly, assets transferred to one of these plans will NOT be included in the donor’s estate for estate tax purposes.

Many of you are probably now familiar with a 529 plan, but parents should also consider the use of a CESA. A CESA is available for individuals with an income less than $110,000 married parents with an income below $220,000 (with a phase-out starting at $95,000 and $190,000, respectively) and permits parents to direct the investments in the account. The disadvantage of a CESA is that no more than $2,000 may be contributed per year for each child, regardless of who establishes or contributes to the accounts. A parent or legal guardian of the designated beneficiary of the CESA, may change the designated beneficiary to a family member of the original beneficiary, provided the new beneficiary is under the age of 30. Unfortunately, unlike a 529 Plan, if the money in the CESA are not used for college, they cannot be refunded to you, but will be distributed to the designated beneficiary thirty days after such beneficiary attains age 30, if the account is not rolled over prior to that date.

There are two types of 529 plans, a prepaid plan and a savings plan. A prepaid plan allows the parent to prepay the tuition at an eligible educational institution, thereby guarding against the inevitable tuition increases. A savings plan involves investment in mutual funds that will grow tax free. Anyone may open up and fund a 529 for a child. The account owner retains may change the beneficiary to any other member of the original beneficiary’s family without adverse tax consequences. Further, although there is no annual limit on contributions to a 529 Plan, generally a person will not want to gift more than the annual exclusion amount (currently $12,000) or it will be a taxable gift to that child. A special gift tax election may be made to gift up to 5 years worth of contributions to a 529 plan in the first year, but no other tax free gifts may be made to that child for the next 5 years. It should be noted that if the donor dies prior to the expiration of the 5 year period, a portion of the gift will be added back to the donor’s estate when calculating the estate tax.

Unqualified distributions from either a CESA or a 529 plan will result in a tax on the accumulated income plus a 10% penalty tax.