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The Other Child Tax Deduction – Part I September 17, 2006

Posted by federalist in Taxation.
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There is a straightforward way to avoid a few more taxes for anyone with children and a bit of investable money: Dependents do not have to file a tax return on unearned income of up to $800 in a year.  So as soon as your child gets a social security number, buy him a (taxable) bond or CD with an $800/year fixed payout.  That’s $800/year of investment income that your family will not be taxed on.

(According to the same IRS Publication 929, your child can actually collect up to $1600/year in unearned income before your tax rate will kick in, so if you don’t mind filing a tax return for them (or they’re already filing for another reason), it may pay to give them more investments.)

What should your child do with that income?  It may make a reasonable allowance:  I was intrigued by Christina Binkley’s article last month on allowances.  Being a fervent capitalist I always assumed I would give my children an introduction to the markets at a young age by making them work for their allowance.  But this article made me rethink that, and I am now convinced that a fixed allowance is the right approach for the following reasons:

  • For markets to work, the consumer of a service must be willing to pay as much as the supplier demands.  It is very unlikely a child would assign the same financial value to a job as you would.  The wage a child demands is probably tied more than anything else to the difficulty of nagging you to buy him what he wants.  Meanwhile, the parent probably values the ethics work instills in children more than the work itself.  Finally, if a child is given the opportunity to pay a forgone wage to avoid work, parents may be dismayed to discover just how much children value watching TV or playing.
  • In any case, a functional family is not a micro-market, but rather a fascist pact.  After all, healthy families can’t shop around for different parents or children, and they don’t function well when everyone is keeping accounts of who has contributed what or taken which personal advantage.
  • Children should certainly be trained to internalize the value of money and sound financial management and planning.  But allowances, loans, and investments should be outward facing.  Children should understand that within a family sacrifice and work are a birthright, and that they only grow greater over life.
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1. federalist - September 30, 2006

*Specifics: At present you can get an FDIC insured CD yielding 5% annually with up to a 5-year term at many banks — e.g., ingdirect.com. So open an account in your child’s name and deposit up to $16,000. (There is a $12k/year gift tax exclusion, so you and your spouse can together transfer up to $24k/year to each of your children.) This $16,000 investment will produce $800/year of tax-free interest to your child (assuming he has no other income).

Note that if you’re in the 35% tax bracket you would have to invest $24,600 in the same product to get the same after-tax return!


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