Surprise! A Dramatic Tax Increase for College Students on Scholarship

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%.