Surprise! A Dramatic Tax Increase for College Students on Scholarship

You might call it a case of haste makes waste. The tax cut bill that passed Congress in late 2017, less than two months after an initial version was introduced in the House with nary a public hearing or input from the minority (Democratic) party, has delivered an unexpected tax bill to college students on scholarship.

That portion of their financial aid that pays for anything but tuition and books, known as non-tuition assistance, is considered unearned income and taxed at the same rate as trusts and estates, as a result of the 2017 tax cut legislation. Those rates are 35% on unearned income above $9,150 and 37% on unearned income over $12,500.

The 2017 tax cut legislation dramatically changed the rate on the kiddie tax — which applies to unearned income for almost all children under 18 and many up to age 23 above $2,200 in 2019 after deductions — from the rate of a students’ parents to the trust tax rate.

In a May 9 letter to the chairmen and ranking members of the House Ways and Means Committee and Senate Finance Committee, Ted Mitchell, president of the American Council on Education, noted that the tax change hurts need-based scholarship students, who “are being taxed at the same rates as wealthy individuals,” as well as college athletes on full scholarships, which include funds for housing and other non-tuition expenses, and potentially the 1.4 million students who receive other scholarships and grants. Also affected are the children of deceased military members who receive survivor benefits.

“I am confident that the adverse impact from the [Tax Cuts and Jobs Act] changes to the kiddie tax is an unintended consequence, which I believe you will be anxious to correct,” Mitchell wrote.

The Secure Act, a retirement bill recently introduced in Congress, could deliver that correction. In a separate letter sent May 20, Mitchell thanked House Ways and Means Chairman Richard Neal, D-Mass., for including a “Kiddie Tax Scholarship Fix” in the bill, which is expected to be voted on by the House this week. The fix treats the scholarship portion applied to non-tuition expenses as earned, rather than unearned, income taxed at the student’s income tax rate, which will be much lower than the trust tax rate.

Mark Kantrowitz, publisher and vice president of research at Savingforcollege.com, agrees that Congress should immediately undo this mistake in the tax cut bill but in the long term should end taxation of all scholarship funds.

Congress didn’t start taxing the non-tuition portion of scholarship until 1986, when it created the kiddie tax under that year’s Tax Reform Act to prevent wealthy parents from avoiding taxes on investment income by transferring those assets to their kids. That law was enacted more than a year after work on it had begun and after months of hearings on the Hill.

“Congress benefits when more students get college degrees” because college graduates earn more than double the federally taxed income of high school graduates and therefore funnel more tax money to the government, according to Kantrowitz. “If Congress wanted to improve college enrollment and graduation rates, the easiest thing to do is to stop taxing scholarships.”

Kantrowitz’s data shows that over one-quarter of private scholarships are awarded to students whose families earn more than $100,000, so those students could presumably be hit by the higher tax. When state and Pell grants along with funds from colleges themselves are included, the percent of students from families with incomes above $100,000 drops to around 15%.