A fix for the Kiddie Tax fiasco is included in the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which was attached to the Further Consolidated Appropriations Act of 2020.

The fix appears in section 501 of Title V of Division O of the legislation, which was approved by the House on December 17, 2019 by a vote of 297 to 120 and by the Senate on December 19, 2019 by a vote of 71-23. 

The Cause of the Problem

The Tax Cuts and Jobs Act of 2017 changed the so-called Kiddie Tax, which taxed a child’s unearned income at the tax rates of the child’s parents. Starting in 2018, however, the Kiddie Tax was based on the much higher tax rates for estates and trusts.  

This significantly increased the tax rates that apply to the taxable portion of college grants, scholarships and fellowships and to military survivor benefits of Gold Star families. It also caused low- and middle-income children to be taxed at much higher rates than their parents. 

This table compares the 2018 income thresholds at which each tax rate applies for parents and for estates and trusts. It demonstrates that the higher tax rates for the Kiddie Tax started at much lower income levels.

                                                            

Tax Rate

Parents (MFJ)

Estates and Trusts

24%

$165,000

$2,550

32%

$315,000

N/A

35%

$400,000

$9,150

37%

$600,000

$12,500

Families were shocked when they saw the increase in their tax liability from the Kiddie Tax changes. Many families had to scramble to find the money to pay the big tax bills.

Undoing the Damage

The SECURE Act repeals the change to the Kiddie Tax, reverting to the rules that were in effect before 2018.

This change is effective for tax years that begin after December 31, 2019. 

However, the legislation allows taxpayers to elect to have the change apply retroactively to the 2018 and/or 2019 tax years. Taxpayers will probably have to file amended federal income tax returns to claim a refund of the excess tax. 

What? Scholarships are Taxed?

Although this amendment fixes the immediate problem, it still raises an important question: Why does the federal government tax college scholarships, fellowships and grants in the first place? 

Even members of Congress are shocked to learn that college scholarships, fellowships and grants are taxable.

Taxing scholarships, fellowships and grants prevents students from making full use of their financial aid and contributes to the student loan debt problem. College scholarships, fellowships and grants are one of the only types of generosity that is taxed by the federal government.