The so-called "kiddie tax" is not really a specific tax at all. Instead, it refers to the limitations that the IRS has placed on the ability of a child under the age of 14 to have unearned income taxed at that the child's lower tax rate.

The "kiddie tax" provisions work like this:

-- The first $650 in unearned income (i.e., interest, dividends, capital gains, etc.) is not subject to tax, either at the child's rate or the parent's rate.

-- Unearned income of more than $650 and up to $1,300 is taxed at the child's rate (generally 15%, and usually much lower than the parent's rate).

-- Unearned income of more than $1,300 is taxed at an adjusted parent's rate (unless the child's rate is greater... not likely but possible).

The "kiddie tax" rules DO NOT apply if:

-- The child is under age 14 and neither parent is alive at the end of the taxable year,

or

-- The child is age 14 or over as of December 31st of the taxable year.

Filing the Tax

There are two ways to file and pay the "kiddie tax." The child can file her own return and compute the "kiddie tax" on Form 8615, or the parents can report the child's income on their own tax return using Form 8814.

Before passage of the Small Business Protection Act in August of 1996, the best method was almost always: "File the child's return alone, using Form 8615." But that Act corrected the "quirk" in the law that provided a greater benefit for the child filing an individual return. Now that parent and child are back on a level playing field, you must determine the method that will be most appropriate for your situation.

How to Beat the System

First of all, if at all possible, keep the reported unearned income below $650 for each child until they reach age 14. Barring that, at least keep the income below $1,300 to avoid paying tax on the unearned income at the adjusted parents' tax rate (more on that rate later).

How to do this, you ask?

1. Series EE Savings Bonds are a good technique. Certainly not very Foolish, but you can elect that the interest on the bonds not be recognized until sometime after the child reaches age 14.

2. Invest in growth stocks that don't pay dividends and that you won't sell until after the child reaches age 14.

3. Watch out with mutual funds. They are required to pay out dividends and capital gains on an annual basis resulting in... oops, unearned income. Instead of mutual funds, you might want to plan on building a stock portfolio for your child.

4. And for goodness sake, don't invest in double tax-free municipal bonds or municipal bond funds until the taxable earned income is greater than $1,300.

The reasoning behind #4? I had a client who invested his kid's money in a municipal bond fund. The problem was the bond fund was the entire investment, and only generated about $400 per year. I advised him (after I slapped him... just to get his attention) that even if he went to a simple taxable money market account, the earnings would stillbe under $650 and therefore not subject to anytax. He was costing the kid about $250 a year just trying to beat the system, but losing track of the big picture. (PS: Don't worry about the kid... I put her in touch with a good attorney!)

The Tax Rate for above $1300/year

The tax rate used in computing the "kiddie tax"is the rate that would apply to the parents ifthe child's net unearned income was added to the parents' taxable income. This could put the child's income in a higher tax bracket than the parents.

The Multiple Children Problem

Having two or more children confuses the issue. The tax rate for the children is now computed by adding the net unearned income of all under-14 children to the parents' taxable income. The resulting tax is allocated among the children based on their share of income.

Conclusion

The "kiddie tax," while a valuable part of your tax strategy, can lead to some confusion. Keeping the above tips in mind while planning your child's investments will make this planning easier. Also helpful to the planning process is IRS Publication 929, "Tax Rules for Children and Dependents." To receive this publication, call 1-800-TAX-FORM and request it, or download the document from the IRS Web site.