When it comes to college planning, our lawmakers created some real traps.

One big trap is the kiddie tax. This insidious tax destroys the traditional IRA as a college funding source and does much the same to your child’s interest and dividends savings.

There’s much to know here. For example, consider the three questions and answers below:

Question 1. Does the tax code penalize children who accumulate a college nest egg and currently have $7,000 in dividends and interest that they use for college?

Answer 1. Yes, more than likely!

Question 2. Does the tax code penalize children who withdraw $7,000 in funds from a traditional IRA and use that money for college?

Answer 2. Yes, more than likely, but not as you would expect.

Question 3. Does the tax code penalize children who withdraw $7,000 in funds from a Roth IRA and use that money for college?

Answer 3. No, not if the withdrawal is from contributions only.

The problem in questions 1 and 2 is the kiddie tax. It applies the parents’ highest tax rate to the under-age-24-student child’s unearned income when

  • the child’s unearned income is more than $2,100, and
  • the child’s earned income is not more than half of his or her support.

The kiddie tax applies regardless of whether your child is your dependent if the child’s earned income is not more than half of the child’s support.

Example. Jane sells stock for $90,000 that her grandmother gave her. At the time of sale, the stock has a basis of $10,000, and that produces an $80,000 capital gain. Jane uses the $90,000 for living expenses and college. Her parents provided none of her support for the year. But because of the kiddie tax, Jane pays taxes on the $80,000 capital gain at her parents’ tax rate.