Taxing college scholarships: A travesty to low-income and middle-class students

The passing of the April 15 deadline for Americans to file their tax returns did nothing to quiet the noisy political and policy debate over the pros and cons after the first year of the Tax Cut and Jobs Act of 2017.

But buried in the new tax law is a provision that so far has gotten little attention but is a major and unwelcome surprise for hundreds of thousands of low-income and middle-class college students and their families: The legislation sharply increased the tax levied on the portion of scholarships set aside for expenses such as room and board that colleges and universities award to deserving students from families of little or modest means.

{mosads}The bottom line: these students are now being taxed at the same rates as wealthy individuals.

Also greatly affected by this hidden tax hike: college athletes on full scholarships, many of them, of course, who also come from families of little or modest means.

Since 1986, scholarship money that is not for what is considered direct educational expenses such as tuition and books has been taxed under something called the “kiddie tax.” Under the kiddie tax, a child’s unearned income was taxed at the rate of her parents.

For low-income college students, this was a very low tax rate. But now this scholarship money — regardless of how little money a student’s family makes — is being taxed at the same rate that applies to trusts and estates.

To give proponents of the tax law the benefit of the doubt, this draconian tax hike on the backs of low-income and middle-class college students and their families is a mistake, but one that too many of our students and their parents just paid dearly for.

The average student and his or her parents had no idea that they would wind up owing far more in taxes for 2018 than anticipated, simply because that student received a college scholarship. 

Here’s the real-world impact on a hypothetical student:

Jessica is a full-time undergraduate age 20, claimed as a dependent by her parents, who have an income of $50,000 a year and jointly file as a married couple. Jessica got a full scholarship for the total cost of her education at a private university, which includes tuition, room and board, books, and supplies.

Good news, right? Not so fast. Roughly $11,500 of her scholarship is subject to taxation, because it pays for room and board and similar expenses. If that money was taxed under the same 12 percent rate that applies to her parents’ regular income, the amount owed would be less than $1,400. But because it is taxed at the higher trust and estates rates of up to 37 percent — which means a portion of Jessica’s money is taxed at the near top rate of 35 percent — her parents owe more than $2,600, an 85 percent increase.

Ironically, a family with an income of $100,000, for example, actually will pay less than under the old tax law, and essentially the same as low-income families.

This unfair new tax hike is affecting nearly 1.4 million college students and their families, but the damage does not stop there. It hits individuals outside higher education too, such as some “Gold Star” families receiving survivor benefits.

CBS News highlighted the case of a widow whose husband, a Navy helicopter pilot, died in the Red Sea during Operation Enduring Freedom in 2013; she saw the taxes on the survivor benefits for her and her two young sons increase to $5,400 from about $1,100.

Back when the tax bill was being debated, lawmakers abandoned a number of misguided ideas that were in the original House version of the tax bill. They did so because it became clear that proposals to eliminate longstanding provisions designed to help a wide range of middle- and lower-income students and their families finance a college education would have set back by decades the widely held desire to make college more affordable and accessible for individuals from all walks of life.

But whenever Congress rushes to pass complex, inadequately vetted legislation, mistakes inevitably occur. This is not new, and in years past, both sides of the aisle on Capitol Hill would easily come together to fix this type of error.

In an ideal world, of course, the federal government would not tax any portion of the scholarship funds awarded to needy students, though that’s almost certainly a step too far for most policymakers at the moment.

But at the very least, low- and middle-income students and their families should not pay more in taxes because the tax writers erred. Indications are that tax writers in Congress are working on a legislative fix. It can’t come soon enough.

This is a mistake that lawmakers must fix — and do so now.

Ted Mitchell is the president of the American Council on Education (ACE) in Washington, D.C.