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Last Chance Tax Move

Starting next year, more kids will lose their favorable rate on investment income.

Attention, parents of high school seniors and college students: Congress just changed the "kiddie tax" rules -- again -- and the news isn't good. You'll have to act soon to take advantage of the current, more-favorable tax law before higher rates kick in next year.

First, some background. The kiddie tax, which taxes certain investment income of children at their parents' higher rate, now affects kids younger than 18. (Before 2006, it applied only to children younger than 14.) This year, the first $850 of a child's unearned investment income is tax-free and the next $850 is taxed at the child's rate. Unearned income in excess of $1,700 is taxed at the parents' higher rate. (Your child's account would have to exceed $34,000, assuming 5% earnings, before triggering this year's tax.) Starting in 2008, the kiddie tax will be expanded to include dependents younger than 19 and dependent full-time students younger than 24.

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So if your child is between the ages of 18 and 23 by the end of this year, you may want to sell at least some of his or her assets to take advantage of the lowest, 5% capital-gains rate for investments held more than one year. Next year, your child's investment income above a certain threshold (this year's limit of $1,700 is indexed for inflation) could end up being taxed at your 15% capital-gains rate. The tax spread is even more dramatic for profits on short-term investments held less than one year and for interest income, both of which are taxed at ordinary income rates ranging from 10% to 35%.

Because of the tax changes, now is also a good time to give children in the 18-to-23 age range appreciated assets that they can sell this year to enjoy the lower rates. An individual can give each recipient up to $12,000 this year without triggering the gift tax. Let's say you and your spouse gave your child $24,000 worth of appreciated stock, of which $12,000 represented profit when sold. Shifting from your 15% capital-gains rate to your child's 5% rate would save $1,200 in taxes.

Stricter kiddie-tax rules also mean that dependents younger than 19 and full-time students younger than 24 won't be able to cash in on the 0% capital-gains rate that will apply in 2008, 2009 and 2010 for taxpayers in the two lowest tax brackets. The new rules make 529 college-savings plans more attractive than ever because withdrawals used for qualified education expenses are tax-free and avoid the kiddie-tax issue altogether.

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