Is My Child’s Scholarship Taxable?

As the cost of higher education rises, families are on the lookout for ways to offset these skyrocketing costs – many times in the form of scholarships to offset all, or a portion of, the tuition.

In many instances, scholarships are NOT taxable to the student; however, some of these funds might be considered taxable to the student, and this income (unearned income – think interest, dividends, rent) would be subject to the “kiddie tax”, which is taxed at estate and trust tax rates, rising quickly like a hockey stick to as high as 37% on income exceeding $12,750.

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The “kiddie tax” came to us in the Tax Reform Act of 1986, as a result of perceived abuses by wealthy parents who were moving their own investments into the names of their children. It originally applied to children under the age of 14, but you and I know that politicians like to spend money, so the applicable age has risen accordingly.

IRC Section 117 excludes from gross income scholarship funds used to pay qualified tuition and related expenses at qualified institutions by candidates for degrees at those institutions.

What are qualified expenses?

Tuition, fees, books, equipment that are required by the school in order for the student to attend class(es).

What are non-qualified expenses?

Expenses such as room, board, travel or anything else not considered qualified tuition or related expense.  Many people often assume room and board are qualified expenses; however, they are not qualified expenses and therefore subject to taxation.  Optional textbooks or equipment do not qualify.

Exceptions for Athletic or Other Scholarships

The IRS, because of Revenue Ruling 77-263, has not included in gross income those scholarships that require effort from the student, such as sports teams and choral or music groups.  Even with recent tax reform, the IRS is choosing to tread lightly in this area.

Example:

Suppose a student receives a “full-ride” scholarship totaling $57,000.  Of the $57,000 awarded, $12,000 is determined to cover room and board and is not a qualified expense; therefore, the $12,000 will be taxable to the student as unearned income.  The student will have $12,000 of gross income, offset by the dependent’s standard deduction of $1,050 to arrive at taxable income of $10,950.  The first $1,050 will be taxed at the single rate of 10% (assuming no other income), and the remaining $9,900 will be taxed at the modified estate and trust rates, which are significantly higher.

But My Child’s 529 Plan Covers Room and Board…

Yes, most likely it does.  529 plans are typically more lenient regarding qualifying expenses than Section 117 of the IRC, and allow for room, board and equipment expenses, with some limitations.  It’s important not to confuse these two approaches.

High-Level Strategies to Minimize Unearned Income of Your Student(s): 

1.       Shift more of your portfolios into qualified retirement plans when possible to avoid dividend and capital gain taxation as current year income;

2.       For children with investment portfolios, consider swapping dividend-paying stocks for those that rely solely on capital appreciation until the student reaches age 24, and

3.       Sell stocks with losses to offset potential unearned income.

What to do next

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