Bamboozled May 23, 2019: My kid got a full scholarship. Now he has to pay more in taxes, thanks to the new tax law.

As a parent, I’m feeling pretty lucky.

Our middle child, off to college in the fall, received a full scholarship that includes additional cash for books and other expenses.

So yes, I’m feeling pretty lucky. (Not that luck has anything to do with it. The kid worked hard and earned the full ride.)

But thanks to the new tax plan, my kid may be stuck with a big fat tax bill.

Legislation to provide relief is working its way through Congress, but there’s no guarantee we’ll see a fix.

Here’s what happened.


Unintended consequences

Under IRS rules, only certain parts of scholarships are tax-free – something that’s a surprise to many scholarship recipients and their families.

Scholarships used to pay so-called qualified education expenses, such as tuition, mandatory fees, books and other required items, are free of tax.

But scholarships that pay for room and board or other non-required items are taxable as unearned income to the student.

That’s nothing new.

What’s changed is the tax rate assessed on the funds.

Now, to understand this unintended consequence, let’s dive into the “kiddie tax.”

The kiddie tax deals with the taxation of a child’s unearned income, said Nicole Kaeding, vice president of federal projects for the Tax Foundation.

Unearned income includes non-wage income, such as interest, dividends and capital gains.

“The concern of policymakers is that if children have lower tax rates than their parents, parents will try to take advantage of this difference and transfer some of their unearned income to their children,” Kaeding said. “So, prior to the Tax Cuts and Jobs Act, a child’s unearned income was taxed at their parent’s tax rate, which could reach 39.6 percent, to try and limit this tax-planning option.”

The Tax Cuts and Jobs Act changed that, she said. Instead of using the parent’s tax rate, a child’s unearned income is now taxed at the same rate as trusts and estates.

This is where the ouch comes in.

“For example, the top marginal rate is 37 percent, which is reached at $510,300 for single filers and $612,350 for married couples,” she said. “But for trusts and estates, that rate is reached at $12,751 in income. So while the rate has decreased from 39.6 percent to 37 percent, it is starting at a much lower income threshold.”

The new rates for unearned income in 2018 are as follows: up to $2,550 is taxed at 10 percent, then income from $2,551 to $9,150 is taxed at 24 percent. Next, amounts from $9,151 to $12,500 are taxed at 35 percent. Anything over $12,500 is taxed at 37 percent.

Those income figures go up for 2019, but the tax rates stay the same.***

Compare that to the average cost for room and board – $12,680 for a private four-year college according to The College Board – and scholarship students could be looking at the top tax rates.

While painful for everyone, the change is even worse for lower income families. Their students could be paying 37 percent, a giant hike from their parents’ tax rates, which could be as low as 10 or 12 percent.

Scholarship students aren’t the only ones affected.

Children of fallen military members who receive survivor benefits – which is also considered unearned income – were hit with the higher tax rate, too.


What’s next?

Legislators are now trying to make a fix.

“Historically, after major tax legislation, the long-standing practice has been to correct drafting errors and other technical issues on a bipartisan basis,” said Sen. Chuck Grassley (R-IA), chairman of the Senate Finance Committee. “The families of military heroes who gave their lives serving their country shouldn’t be penalized by an unintended effect of tax reform.”

The committee, earlier this week, moved on a bill that would no longer consider survivor benefits unearned income – but the bill didn’t touch the scholarship issue.

Sen. Bob Menendez (D-NJ), who also serves on the Finance Committee, said he wants a broader fix.

“There’s absolutely no reason college students should have to pay an exorbitant amount of taxes on their financial aid packages while multinational corporations and their CEOs receive massive windfalls,” Menendez said. “This sloppy mistake in the tax bill must be fixed immediately and I’m working with my colleagues to push through legislation that ensures college students are not unfairly hit with a huge tax bill.”

He is expected to introduce a bill later Thursday to address the issue.

Another bill, this one in the House of Representatives, would eliminate all the changes to the kiddie tax, bringing the rates back to where they were before the new tax plan. That’s expected to go to the floor on Thursday, too.

But before we see any legislative correction, Republicans and Democrats in both houses will have to agree to a compromise bill.

Legislators say they’re working across the aisle to solve this one.

For my kid’s tax bill, I certainly hope so.

* for an update on the Senate bill about scholarship taxation, click here.

*** We added a link to see the 2019 trust/estate tax thresholds.

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