This is what I've done---
I saw on a show "Clean House" a great rule of organizing and simplifying tons of clothes for an adult---one size up, one size down, from your current size, everything else goes. (I have modified this to Pregnant Clothes and Not-Pregnant Clothes, but you get the idea)
For the kids---I do save my oldest's stuff for his brother, 4 years younger. BUT--only *certain stuff*--clothes that were dress clothes that look new, clothes I particularly liked, etc. I do NOT save things like cutoff jean shorts, hole-in-knee jeans, stained shirts, etc. Trust me, they *create* enough play clothes of their own! I do not need to SAVE any.
Their drawers (what they can reach) contain their play clothes, and only appropriate to what the weather is MOST of the time currently. This is ONLY stuff that I don't care if they wear it out to play in the mud, etc. And their socks, underwear, swimsuits, and PJ's.
What is hanging in their closet is clothes for when we are going someplace and I actually care a little what they are wearing. They need adult help to reach them, therefore they wear them when I approve it. I am HOPING (since i just started this) that this will be the thing that prevents me from the frustration of not being able to find anything "decent" for them to wear.
In the basket on the top shelf of the closet is clothes that we may need on a rare day--like right now it is summer--definently hot, shorts, etc. but the other day was rainy and cool and they needed pants. But keeping them in a basket on a high shelf prevents them from being thrown all over as they search for shorts or whatever, and it also prevents arguments over wearing clothing that is appropriate to the weather.
Now as far as what to keep--I still have more than this, but as stuff wears out, this is what I'm trying to get down to....
DS who is in school--probably 8 decent shirts, including what I keep for dress clothes for special occasions only. (one might be part of a suit outfit, and this is counting probably 2-3 different shirts appropriate to wear to special occasions since we might go to a few in a short amount of time and DH likes them to not wear the same stuff *all the time.* These I get second-hand to save money because dress clothes rarely look used anyway.)
I do have 4 pairs of jeans for him right now that are 'school condition' but I expect the used pair will soon have a hole in the knee and go to the play drawer, leaving him with 3 which is my goal for 5 days of school.
I have *a lot* of play shirts in his drawer right now, but I would like to get them narrowed down to about 5 as he outgrows some, they get holes, etc. Same with pants, there's no reason he *needs* in my mind more than 3-4 pair of play-condition pants.
The kids who do not go to school can get by with less "going out/nice/not play condition" (which I consider to be the shirts with a small stain or tiny hole or jeans with a hole in the knee, or cutoff jean shorts etc--those are play clothes)
Again, my kids probably right now have more than I'm recommending, but I'm *trying* to narrow it down to...
Maybe 4-5 outfits each--including a couple dresses for my daughter, that are "going out" and "special occasion only" clothing. (anytime I actually care that the clothes are not old-looking/slightly stained, etc.)
Underwear and socks I buy a lot at first--like a 10 pack of socks per kid, 7-8 of underwear etc. so that I don't have to run out and get more when we lose a sock, they get a hole, etc. With the frequency that we do laundry, they can probably get by all right with 4 pair of each. (oh and the extra underwear take into account potty training accidents or "I want to change cause I didn't wipe very good, etc.
And I've simplified by getting them all one type of sock, but they obviously look different--DS1's have the gray heels and toes, DD's are pink, the baby/toddler socks are the ones from Target and have the size written on the bottom so you can tell which are the 2 year olds and which are the newborn's easily.