Kiddie tax changes result in financial aid traps: new law affects planning strategies.

In the past, wealthy parents could significantly lower the family tax bill by transferring investment assets to minor children, resulting in investment income taxed at the kids' (presumably lower) rates. To curtail this, Congress enacted the "kiddie tax," under which children under age 14 who have more than a specified amount of unearned income are taxed at their parents' rate. The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) raised the age limit to 18. This change has reduced the income tax benefits of shifting assets from parents to children--and also negates the efficacy of some traditional financial aid planning strategies.

TAX STRATEGIES

Prior to TIPRA, a common strategy was to invest in instruments that generate low (or no) income, such as growth stocks or savings bonds. When the child reached 14, the instruments were sold or redeemed.

For students unlikely to qualify for financial aid, this strategy is still proper, with 18 as the critical age. However, for students looking for financial aid for their college educations, this strategy now can significantly lower financial aid awards, more than outweighing any possible tax savings.

FINANCIAL AID IMPLICATIONS

Typically, a student seeking financial aid must file an application each year, no earlier than the beginning of the calendar year involved (for example, January 2007 for the September 2007 school year). The applicant must report his or her own and the parents' income for the preceding calendar year and assets as of the date the application is signed.

Generally, 50% of a student's income is presumed to be available to fund college expenses, with the parents' income assessed at rates from 22% to 47%. In addition, 35% of a student's assets are considered in this assessment, but only 2.64% to 5.64% of the parents'.

After TIPRA, a student who holds assets until age 18 and then sells them might have to count these assets and income in the financial aid determination, and therefore may face an income tax liability.

PLANNING

Younger lower-income children with moderately appreciated assets may be in the best position for both income tax and financial aid planning. They may be able to structure sales of appreciated capital assets from 2008 to 2010--when long-term capital gains are tax-free for income normally taxed in the 15% (or lower) bracket and below the kiddie tax's unearned-income threshold.

Young children with more highly appreciated assets should consider systematic dispositions over a number of years. This may spread out income, possibly avoid (or lessen) the kiddie tax and eliminate assets and income from financial aid consideration.

Another strategy involves grandparents. Financial aid applications require information about parents and children. Thus, grandparents who create and own IRC section 529 plans (partially funded by the parents), with a grandchild as beneficiary, could be an alternative.

For more information about this topic, see Personal Financial Planning, "The Expanded 'Kiddie Tax' and the Financial Aid Trap," by Alan R. Sumutka, MBA, CPA, in the January 2007 issue of The Tax Adviser.

--Lesli S. Laffie, editor

The Tax Adviser

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