Kiddie Tax Changes Result in Financial Aid Traps: New Law Affects Planning Strategies
Laffie, Lesli S., Journal of Accountancy
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.
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. …