The Tax Cuts and Jobs Act of 2017 brought many changes to American households – including the way scholarships are taxed for low-income college scholarship recipients. When students filed tax returns this past tax season, they were hit with a tax bill they didn’t see coming.
“Low-income students are already struggling to pay for college tuition, books, and living expenses. Now they must contend with this,” says Theresa Harris, a Chicago-based scholarship strategist at ScholarshipMomma. “Parents and students should inquire about the purpose of each award and the applicable tax treatment associated with all educational proceeds when they receive their financial aid award letters. Seek the assistance of a tax preparer for further guidance.”
If you are a degree candidate at a qualified institution, scholarships covering tuition and fees are tax-free. However, scholarships that cover non-qualified expenses, including room, board, and travel are taxable. For grad school students, assistant-ships and fellowships may also be subject to taxes.
How is a taxable scholarship classified? It can be considered “unearned income” and is subject to the rules of the Child’s Investment and Other Unearned Income, also known as the “Kiddie Tax.” These rules are applicable if the child is under 19, or is a full-time student under age 24.
The Kiddie Tax was enacted in 1986 to prevent wealthy parents from transferring money to their children tax-free. Parents would take advantage of their children’s lower tax bracket to shift wealth and avoid paying taxes on some income. That’s why the kiddie tax classified these funds as “unearned income” and subjected the funds to the same tax rate as a child’s parent. This rule also went into effect for taxable scholarships.
For example, a student from a single parent household with an income of $30,000 who received a scholarship that covered $13,000 in room and board would be taxed at their parents’ rate of 12%.
All thanks to the new rules in place for applying the kiddie tax, scholarship recipients coming from economically depressed communities are now being taxed at the rates applicable to trusts and estates. The student who was previously taxed at their parents’ rate of 12% would now be taxed up to 37 percent – the same rate used to tax single filers with incomes over $500,000.
Here is the new tax structure for trusts and estates. This applies to unearned income (including scholarships) for those in the “kiddie tax” category:
- 10 percent on amounts up to $2550
- 24 percent on unearned income over $2,550
- 35 percent on amounts over $9,150
- 37 percent on amounts over $12,500
So, students who receive unearned income over $12,500 will be taxed the same as a single person with over $500,000 in taxable income.
A new bill is on the table that would completely change the unintended consequence of the 2017 tax law. If the bill passes, college students won’t be punished with a tax rate as high as 37 percent. Instead, scholarship money would be taxed at a lower rate.
“Scholarships are a critical component of the financial aid package that is meant to make college more affordable,” says Harris. “This tax is an added burden, causing additional financial stress for students. Congress needs to act quickly to correct this error.”