The "kiddie tax" refers to the manner in which unearned income is taxed for children. In 2007, the first $850 of unearned income is tax free, the second $850 is taxed at the child's marginal tax rate, and any remaining unearned income is taxed at the parents' marginal tax rate. Once the individual exceeds the age limits, all unearned income is taxed as his/her marginal tax rate.

This change effectively eliminates a common college funding technique of gifting investments to the child as he/she approaches college age and then having the child sell the assets to take advantage of lower capital gains tax rates (5% if the child is in the 10% or 15% tax bracket, instead of 15%). Some families were planning to postpone asset sales until 2008 to 2010, when the long-term capital gains tax rate would be 0% for taxpayers in the 10% or 15% tax bracket.

Since the provision will typically not apply until 2008 for most taxpayers, individuals under age 24 may want to sell assets in 2007 to take advantage of the 5% capital gains tax rate. Another alternative would be to wait until a student turns age 24 to sell the assets. However, there is the possibility that the individual would immediately start working at a job that would put him/her in a higher tax bracket, so the 15% capital gains tax rate would have to be paid anyway. The capital gains tax rate is scheduled to increase from 15% to 20% after 2010, unless further legislation is passed.

To minimize the effects of this new provision, taxpayers with children under age 18 should reevaluate their investments, looking into investments that generate little or no taxable income. Another alternative, if you are saving for a child's college education, is to invest the child's assets in section 529 plans or Coverdell education savings accounts, which provide tax-free distributions as long as the funds are used for qualified education expenses. If the child has earned income, he/she can also set up a traditional or Roth individual retirement account.

Taxpayers who own a business may want to employ their children, especially those in the 14 to 24 age group, since earned income is not subject to the "kiddie tax" rules and is taxed at the child's marginal tax rate. There is added incentive to do so for students over age 17, because the "kiddie tax" rules won't apply for that year if the individual's earned income is more than half of his/her support.