Devoted to understanding the basics and fundamentals of investing

No Kidding Anymore
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Putting income-earning investments in a child's name has long been a popular tax-saving strategy for families. Parents can make gifts to their children AND reduce their own income-tax liability in the process. This kind of income-splitting arrangement was reined in by the so-called "kiddie tax" rules, which were designed to limit the tax savings families could realize. A recent change in the kiddie tax rules limits those savings even further.

It's About The Tax Rates
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In 2006, the first $850 of a child's unearned income is tax-free. The second $850 is taxed at the child's tax rate, which is usually substantially lower than the parents' rate. Under the kiddie tax rules, any ADDITIONAL unearned income is taxed at the parents' rate.

The kiddie tax rules previously applied to children under the age of 14. Beginning in 2006, the rules apply to children under age 18, eliminating four years of potential tax savings.

Opportunities Still Exist
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One way to adjust to this change may be to shift the assets in a child's portfolio away from investments that produce current income and focus on growth-oriented investments, at least until the child reaches age 18. There are also several tax-advantaged possibilities, such as traditional and Roth individual retirement accounts (if the child has earned income), Coverdell Education Savings Accounts, and Section 529 college savings programs. Most (if not all) of these other specific tax-advantaged opportunities have all been addressed elsewhere in this blog.

Roth's Door Opens Wider
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Although Roth individual retirement accounts (IRA's) offer some nice tax advantages, high earners haven't been able to use them effectively, due to tax law restrictions. A new law changes that, starting in 2010.

What Roth Has To Offer
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Roth IRA contributions aren't tax deductible, so taxpayers get no immediate benefit from contributing. But account earnings aren't taxed, and earnings can be withdrawn tax free, once the account owner is at least age 59-1/2 AND five years have elapsed from the year of the first Roth contribution. (Tax-free distributions are also available in certain other situations, as well. Consult a tax professional).

Individuals who prefer to leave their money invested can do so. The tax law's minimum distribution rules don't apply until after the account owner's death. Even then, beneficiaries can typically stretch account withdrawals out over their own life expectancies, if desired. With its many years of tax-free earning potential, a Roth IRA can be an exceptionally good deal for any taxpayers.

Roth Restrictions
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Taxpayers need to have earned income to contribute to a Roth IRA. Even with earned income, taxpayers can't contribute to a Roth IRA if modified adjusted gross income (AGI) exceeds $110,000 (or $160,000 for married-joint filers). If AGI is between $95,000 and $110,000 (beween $150,000 and $160,000 for married-joint filers), a partial contribution is allowed.

Converting To Roth
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A traditional IRA can be converted to a Roth IRA by PAYING TAXES ON THE BALANCE (less any amount attributable to non-deductible contributions). However, if modified AGI, not including income from the conversion, is more than $100,000, a conversion isn't permitted. Married individuals making a conversion MUST file a joint return.

However, these limitations will no longer apply, starting in 2010. Anyone with a traditional IRA will be able to convert it to a Roth IRA, REGARDLESS OF INCOME OR FILING STATUS by then. And, while 2010 seems fairly far off, there is something high earners can do right now to make the most of the liberalized rule.

Roth Strategy
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Contribute now to a traditional IRA and then do a post-2009 Roth conversion. There are no income restrictions on NON-DEDUCTIBLE traditional IRA contributions, even for those of you who are participants in employer-sponsored retirement plans. The tax payable on conversion may be small, due to the nondeductible nature of the IRA contributions. (IRA earnings through 2009 will be taxed). After conversion, all earnings on the Roth IRA balance will be tax free, if you meet the distribution requirements. It's a very good deal, wouldn't you say?