Investing for kids? Keep these dates in mind

If you have young children or grandchildren, you may want to start investing for them – and you should. As you invest, however, you’ll need to keep a couple of key dates in mind – because they can make a difference in your family’s tax situation and your control of your child’s or grandchild’s assets.
One important date to remember is the day your child or grandchild turns 17 – because that’s the last year he or she will be affected by the “Kiddie Tax.” The Kiddie Tax applies to unearned income – typically from investments held in the child’s name – above an annual threshold, which, in 2007, is $1,700. Of that $1,700, the first $850 of earnings is tax free, but the next $850 will be taxed at the child’s rate, which is typically 10 percent. Any income above that $1,700 will be taxed at the parents’ rate, which could be as high as 35 percent.
However, while your child’s or grandchild’s tax rate may be 10 percent, it doesn’t necessarily mean that every investment that generates $850 in earnings will be taxed at that same rate. For example, a child will only have to pay a 5 percent tax rate on income from most types of stock dividends. (At least, that’s the case for now; Congress is considering legislation that would subject the $850 – or whatever the future amount may be – to the 10 percent rate, no matter what the source of the income.)

On the other hand, if a child invests in growth stocks – those that generally don’t pay dividends – he or she won’t generate significant unearned income until after the shares are sold. So, if you and your child or grandchild follow a “buy and hold” strategy with these stocks until the child is at least 18, he or she would only have to pay the capital gains tax, which is currently just 5 percent for people in the 10 percent tax bracket. (This rate drops to 0 percent for the years 2008 through 2010, but the proposed legislative changes would deny the 0 percent rate to children.)
Once your child or grandchild turns 18, he or she will no longer be affected by the Kiddie Tax. The age of 18 is also important if you’ve been investing for your children or grandchildren through either the Uniform Gift to Minors Act (UGMA) or the Uniform Transfer to Minors Act (UTMA). Essentially, UGMA/UTMA allows you to fund an account for a child, but limit the child’s access to the account until he or she reaches the age of majority – either 18 or 21 in most states. The child owns the account, but you are named as custodian, and you control the account until the child is no longer a minor. At that point, the custodial relationship ends and the child assumes control over the account.
In other words, once the child is 18 (or 21), there’s no guarantee that he or she will use the money for college, as you may have intended. So, if you really want to put all your child’s investment money into a college fund, you might want to consider a 529 College Savings Plan, which gives you significant control over the funds, along with tax advantages. Contributions are tax-deductible in certain states for residents who participate in their own state’s plan. You should note that a 529 College Savings Plan could reduce a beneficiary’s ability to qualify for financial aid.
In any case, if you’ve got investments earmarked for your children or grandchildren, be aware of the changes that will occur once they turn 17 and 18. Those years can be challenging enough without any financial “surprises.”