Children under age 18 pay no tax on their first $1,700 of unearned investment income. Any additional income is taxed at their parents' highest marginal tax rate. This is called the "Kiddie Tax." Consider several options to avoid paying at this higher rate.
First, shift the child's investments to tax-free securities or growth stocks (which don't pay dividends) that defer taxes until the child's 14th birthday.
Or, divide the child's income with a special trust. Only undistributed income is taxed to the trust, and distributed income is taxed to the child. Unfortunately, trust tax rates are very compressed, reaching the maximum individual rate of 39.6% at a taxable income level of only $8,450 in 2003. At age 21, or when the child meets your specifications, the child will receive all principal and accumulated earnings, which will have tax consequences.
Another option is to report your child's income on your return. This allows you to take advantage of your child's capital gains dividends to offset your capital losses that may otherwise be limited.
IRAs FOR KIDS
If your child has earned income from outside the household, such as from a summer job or baby-sitting, consider sheltering it with an IRA. Children can make IRA contributions up to the lesser of $3,000 (years 2002-2004) or their earned income.
Suppose your daughter saves $800 from baby-sitting when she's 15 years old and purchases a Roth IRA. If she makes no additional contributions and the funds grow at a 10% rate, she'll be able to withdraw over $93,900 tax-free at age 65. Or, suppose your son purchases a $2,000 Roth IRA when he's 15 years old and continues making $3,000 deposits for 10 years. The value of his tax-free fund balance at age 65 will reach about $1,545,000 if the interest rate is 7%.
Consider a deductible IRA, Roth IRA, and Education Savings Account (ESA) for your child.