Unexpectedly Intriguing!
January 25, 2006

One of the reasons the U.S. federal tax code is so freaking large and complicated is that it has often been revised and extended for the sake of attempting to achieve public policy goals through positive and negative incentives. "Desired" behavior is often rewarded through tax credits. Meanwhile, "undesired" behaviors are punished by exposing individual tax payers to higher tax rates than would otherwise be needed, largely to subsidize the tax breaks that the "lucky" few are receiving.

That, in a nutshell, is the system we've got. The questions now become: "How can we cash in on stuff like this?" and "How much cash are we talking about?"

If you're one of the "lucky few" who have kids under the age of 14, you might consider taking advantage of the incentive our hard-working federal tax code writers have provided to reward you for setting up investment income accounts for your children. Here's how it works:

  1. Set up an investment account for your child, or each of your children, where they are able to accumulate interest or dividend income.
  2. The first $800 they earn for 2005 (or $850 for 2006) is exempt from being taxed.
  3. The second $800 they earn (or $850 for 2006) is taxed at a flat tax rate of 10%.
  4. Any amount over $1600 (or $1700 for 2006) is taxed at the parent's tax rate.

That's pretty much it, although there's a bit of paperwork to be able to realize the tax advantage. The following tool we've created below estimates the amount of the tax break you might realize from exploiting this option by comparing it to what you would otherwise have to pay out of your pocket if you had invested it yourself and had to pay the full tax on the unearned income. Credit for the idea behind this tool belongs to the Early Riser, who first described how the credit works in 2005 and recently updated the information for 2006. The tool below uses the revised data for 2006 to calculate the tax savings, but your tax data for 2005 to estimate the parent's marginal tax rate:

Parent's 1040 Tax Return Data for 2005
Input Data Values
Line 63: Taxes Owed ($USD)
Line 22: Total Income ($USD)
Line 8b: Income from Tax Exempt Bonds ($USD)
Filing Status
Line 37: Taxable Income ($USD)
Your Child's Unearned Income
Amount of Interest and Dividend Income ($USD)

Estimated Taxes Paid on Unearned Income
Estimated Results Values
Parent's Marginal Tax Rate (%)
Taxes Paid if Income Taxed Fully at Parent's Rate ($USD)
Taxes Paid if Income Taxes at Child's Rate ($USD)
Potential Tax Savings ($USD)

You will need to repeat this exercise for each of your children who qualify for this particular tax savings technique. Those with more children get more tax savings.

And yes, it does occur to me that this particularly tax credit is set up to benefit the proverbial "trust-fund" baby (whose parents, after all, have the money to lobby the U.S. Congress to write things like this into the tax code.) But, as long as it's there, there's no reason that otherwise unassuming middle-class folk can't exploit this particular legal tax-avoidance scheme too....

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