Understanding a Child's Tax Capacity - Age 14 through High School Years When a child reaches age 14, the Kiddie Tax rules no longer apply.  Therefore, the financial advisor should be aware of the child's tax capacity.  This increased tax capacity should be factored into the college funding plan for the affluent family. Example:  In year 2004, a 17-year-old child has $3,000 in wages and $2,000 in unearned income. The child's standard deduction is $3,250 ($3,000 + $250).  The child's taxable income is $1,750 ($5,000 - $3,250). During this time frame, the student will have a low 10%/15% tax bracket threshold of $28,400 for year 2004.  Therefore, the student will have a combined tax capacity of $33,150 for year 2004 ($4,750 + $28,400).  This amount of income can be shifted to the child from a parent (or grandparent) and be sheltered from the parents' higher income tax bracket.  Wealthier parents, whose income prevents claiming of the new educational credits in the parental tax return, appear to also be precluded from claiming the tax credits in a dependent child's return (i.e., where the student is a dependent because over half of support is provided by parents).  This is particularly an issue in the student's senior year in high school and freshman year in college, when over half of the student's support comes from the parents, but their 1040 income prohibits use of the Hope credit for the freshman tuition. In early 1999, the IRS issued a proposed regulations dealing with the education credits (Prop. Regs. 1.25A-1 through 1.25A-5, REG-103688-98, 1/6/99).  The proposed regulations provided an elective opportunity to claim Hope or Lifetime Learning credits in the return of a dependent child.  The regulations provide that if the parent is eligible to, but does not, claim the student as a dependent , the student may then claim the education credit for the student's qualified tuition  and related expenses [Prop. Reg. 1.25A-1 (g)(1)]. Observation:  In most cases with wealthier parents, the child's dependency exemption provides little or no benefit, due to the phase-out which occurs at higher income levels.  The phase-out range for joint filers for 2004 is $214,050 of AGI to $336,550, and for single filers from $142,700 to $265,200.  Declining to claim a dependent above these AGI phase-out ranges, of course, is of no detriment to the parental return.  However, even for lower income parents, the 2004 dependency exemption for a student can only produce at best $1,068 of tax savings (e.g., $3,050 deduction at 35% federal rate = $1,068), whereas an education credit can produce $1,000 to $1,500 of federal tax savings in the student return, assuming the child has sufficient income tax against which to consume the credit.  Note also that the parent's election to decline the dependency exemption does not shift the deduction to the child's return (i.e., the child is still ineligible by reason of not providing over 50% of own support). To find out more about tax capacity strategies, please call me at (573) 334-8474.   Return to Education Startegy