At one time, wealthy parents could significantly lower their family's tax bill by transferring investment assets to minor children. This tax technique, called income shifting, worked by taking income out of the parents' higher tax bracket and placing it in the lower tax brackets of their children. To curtail the use of this tax technique, Congress enacted the “kiddie tax” rules, which said that children under 14 who had more than a small amount of unearned (investment) income had to pay tax at their parents' marginal tax rate (the rate of tax on the last dollar earned). The threshold amount at which the kiddie tax kicks in is two times the amount allowed as a standard deduction for a dependent who has only investment income. For 2006, that amount is $850, so the kiddie tax begins to apply when the child has more than $1,700 in unearned income.

Here are the 2006 income limits:

Under the new law, the age limit below which a child's income from investments is taxed at the parents' rate is raised from 14 to 18. The new law specifies, however, that the kiddie tax does not apply to a child who is married and files a joint return for the tax year. The new provisions apply to tax years beginning after Dec. 31, 2005.

Example.  Assume the following:  Jill is 17 years old, has no earned income but generates taxable interest income from investments in 2006.  Her parents are in the 35% tax bracket.

For the $20,000 investment, Jill’s tax liability would be $35 and $120 for the $30,000 investment.

Note that in many instances, the kiddie tax will not be a factor.  In fact, it’s advantageous when a child can generate taxable investment income up to the kiddie tax threshold amount since the income is either not taxed or taxed at a very low tax rate.