Tax Rates on Scholarships Triple

Mark KantrowitzBy Mark KantrowitzBy Savingforcollege.com

Scholarships used to pay for tuition and textbooks are tax-free, but scholarships used to pay for other expenses, such as room and board, are treated as taxable income to the recipient. A change in the Kiddie Tax enacted by the Tax Cuts and Jobs Act of 2017, however, triples the tax rates on such scholarships.

[Editor's Note: The Setting Every Community Up for Retirement Enhancement (SECURE) Act, which was enacted on December 20, 2019 as part of the Further Consolidated Appropriations Act 2020 (P.L. 116-94), repealed the change to the Kiddie Tax. In 2020, the first $1,100 in a child's unearned income is tax-free and the second $1,100 is taxed at the child's tax rate, with unearned income over $2,200 taxed at the parent's tax rate.]

What is the Kiddie Tax?

The Kiddie Tax is designed to prevent parents from shifting unearned income, such as interest and dividends, to a child to take advantage of the child’s lower tax brackets.

The Kiddie Tax applies to children with more than $2,100 in unearned income, based on certain criteria that depend on the age of the child at the end of the tax year, as shown in this table.

Child’s Age

Enrollment Status

Support Test

< 18

N/A

N/A

18

N/A

Unearned income provides ≤ half of the child’s support

19-23

Full-time student

Unearned income provides ≤ half of the child’s support

Unearned income includes taxable scholarships and grants, as well as the earnings portion of a non-qualified distribution from a 529 plan.

Before 2018, unearned income was taxed at the parent’s rate. The Tax Cuts and Jobs Act of 2017 switched it to the tax rates for trusts and estates, with a goal of simplifying the Kiddie Tax. Unfortunately, this significantly increases the tax rates on unearned income, which includes college scholarships and non-qualified distributions from 529 plans.


Financial Impact of the Changes in the Kiddie Tax

The changes in the Kiddie Tax switched the taxes on unearned income over $2,100 from the parent’s tax rate to the tax rate for estates and trusts.

This change does not matter for wealthy parents, but it does matter for low-income families.

If the parents are low-income, the parent’s 2018 tax rate is 10% or 12%.

The tax rates on ordinary income and short-term capital gains for estates and trusts, however, ladder up very quickly, as shown in this table.

Taxable Income

Marginal Tax Rate

Less than $2,550

10%

$2,550 to $9,150

24%

$9,150 to $12,500

35%

$12,500 or more

37%

For example, a student with a $15,000 college scholarship for room and board might have to pay $3,936.50 in taxes on the scholarship under the new Kiddie Tax, up from $1,500 under the old Kiddie Tax. The family must pay more than a quarter of the scholarship amount in taxes.

Since scholarships must be used to pay for college costs, the family must find some other source of funds to pay the taxes on the taxable portion of the scholarship. This can be challenging for low-income students.

Workarounds for the Kiddie Tax Changes

There aren't any really good workarounds for the Kiddie Tax changes. Ask the scholarship provider if the scholarship can be used to pay for tuition and textbooks instead of room and board. That would make it tax-free instead of taxable. Or, ask if a non-renewable scholarship can be spread out over all four years or have part of it deferred to graduate school.

The only real solution is to ask Congress to revert to the previous Kiddie Tax rules or make scholarships entirely tax-free.

Flaws with the Changes in the Kiddie Tax

More than 3 million scholarship recipients may be affected by this change in the Kiddie Tax, because taxable scholarships are treated as unearned income.

But, why are scholarships taxed?

Taxing scholarships prevents students from making full use of their scholarships.

Scholarship providers are reluctant to provide scholarships for room and board and other taxable college costs, since the tax liability makes the scholarship less effective in making college more affordable.

College scholarships is one of the only forms of generosity that is taxed. People aren’t taxed on the benefits they receive from a soup kitchen or homeless shelter, but they are taxed on scholarships that are used to pay for room and board.


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