The 1 Pitfall Nobody Knows About with Scholarships that Can Be Avoided
Updated: Jun 24
In this video, we educate our viewers about how certain scholarships can trigger a taxable event and count as unearned income to the student. We cover how to determine what is and what isn't taxable. How to potentially minimize the impact, even when you know you will incur the kiddie tax.
Watch Ian & Scott with Mellen Money Management, a fee-only financial planning and investment management firm in Nocatee, FL. In this episode, they discuss why and when scholarships are taxable. They also discuss if there are any changes on the horizon in terms of how the taxation of scholarships are treated and if there is anything you can do now to limit the damage.
MAIN TOPICS WITHIN THE VIDEO
Why don't more people know?
Is anything being done to help?
How do you know what is taxable?
How can you minimize taxes on scholarships?
Scott : [00:00:11] Hello, this is Scott Snider, and I'm here with my business partner Ian Aguilar at Mellen Money Management. We are a fee-only financial planning firm in Nocatee, Florida. And we're here to talk about the one pitfall nobody knows about scholarships that can be avoided.
Scott : [00:00:31] So, Ian, we're gonna start with a little bit of Q&A and let Ian explain to us and go from there. So talk about the taxability of scholarships and why doesn't anybody really know about that?
Ian: [00:00:47] Yeah. You know, it's kind of funny. People get these scholarships and don't really think about it.
Ian: [00:00:51] I think maybe it's partly because of the fact that they're so excited at that one point in time.
Ian: [00:00:59] And also not all scholarships are taxable.
Ian: [00:01:03] So there's some interest to that. And then thirdly, it's just because they weren't even taxed back in before 1986. 86 is the year they first started getting taxed. It was some sort of thing that Reagan and his party basically put in as a way to lower taxes across the board for everyone. They just stripped away a bunch of different loopholes. This is one of them and made it so that people that use scholarships in relation to expenses that weren't directly qualified educational expenses, that they got taxed on those scholarships and was treated as income. And that hasn't changed since then. It's been like that since 86.
Ian: [00:01:48] So there's a section of expenses like your actual tuition, your books, anything you buy in relation directly to the education that you don't get taxed on with the scholarships are used for that. It's when scholarships are earmarked for things like room and board or if you're spending money on transportation between school and home. That's when the scholarships are deemed taxable.
Ian: [00:02:22] Even work-study programs, the stuff that you get in the financial aid packages when you're working for the school. Those are oftentimes taxable incomes. And people don't realize that. This can sometimes work up to a decent chunk of change, especially when kids are struggling to make ends meet and they get hit with a $1,000 tax at the end of all of it.
Scott : [00:02:50] I mean, how many people knew room and board was taxable? I certainly didn't know that.
Ian: [00:02:57] Not a lot. And to be honest, this is the thing. So the government as a whole wasn't making a lot of money on this because people just weren't claiming it as often, maybe back in the day. I mean, even 2015.
Ian: [00:03:09] You see the last couple of years. 2015, the revenue was around 325-million dollars that the government made off of taxable scholarships. In 2017, the last year we have numbers for right now, it is 2.8 billion dollars. Not a huge surge. Really isn't because the scholarships.
Scott : [00:03:26] So they are looking at it closer now?
Ian: [00:03:29] Exactly.
Scott : [00:03:29] So I have to imagine that there are quite a bit of people out there that have filed their tax returns not knowing my kid got this scholarship full ride to Florida. Oh, and by the way, that room and board part is now taxable.
Ian: [00:03:47] Yeah, exactly.
Ian: [00:03:49] And so you look at the expenses in regards to when you go to college, I mean room and board is a large chunk of it.
Ian: [00:03:58] So if you're getting money in regards to that. That's going to be taxed.
Scott : [00:04:01] Absolutely. So what's being done now that people are paying more of this tax?
Ian: [00:04:10] You're starting to see, especially now with the pandemic, right. People are a little bit more sensitive to paying for things that they feel like they shouldn't have to pay for. Scholarships are one of those. I guess the American Council on Education sent over a proposal this last month. They want to get some sort of relief similar to what people are getting from student loans. They made that whole gap and making it so that people don't have to pay their on their school loans right now. They want similar treatments for in particular really the people who are on the lower end. They want to be able to limit or just cease the taxations of scholarships for people who need assistance on paying for college to begin with. When you're taxing them on the money that they're getting for assistance, it somewhat defeats the purpose in their minds.
Ian: [00:05:06] So they're really pushing for that and hoping to get that through just from a law making standpoint.
Ian: [00:05:11] You know, I haven't heard how people have reacted to that on the Hill. It sounds rational. But, you know, there's all different kinds of feelings and I'm sure that people don't want to wait.
Scott : [00:05:24] Everyone's looking For a handout from COVID.
Ian: [00:05:27] And also, 2.8-billion dollars. That's a lot of money. So, you know, I don't see that. I don't see the taxation as a whole being stripped away... Or maybe to a certain extent.
Scott : [00:05:39] Yeah. So how do people find out about their taxable portion from their scholarship? What sort of resources exists for them?
Ian: [00:05:47] Well, technically, every year everyone gets a what's called a 1098-T. It's just a form getting sent out from schools.
Scott : [00:05:58] Similar to a 1099-R that people get from their brokerage company.
[00:06:03] Exactly. It will also tell you how much in scholarships you receive, how many qualified educational expenses you had.
Ian: [00:06:13] You typically have to go a step further because they're not going to break down for you. They're not going to tell you what part is taxable or isn't.
Ian: [00:06:21] And that's where most of the financial aid offices will help you with that if you reach out to them. Again, making note of the work-study fact. But for you as a taxpayer, you definitely want to keep track of what you spent on things like textbooks, supplies and equipment for four classes.
Ian: [00:06:40] Keep receipts for that stuff because then you can add that as part of your qualified expenses that wouldn't show up on your 1098-T. Because all they see is the stuff that you're paying next to the school itself.
Ian: [00:06:52] The Wall Street Journal actually came out with an article a few weeks ago that actually has a link and we'll link it to show notes.
Ian: [00:06:58] But a page that walks you through a simple calculation to try and get to what your taxable portion of scholarship's is.
Scott : [00:07:10] Interesting. So is there anything that parents can do to avoid this issue?
Ian: [00:07:17] Yeah, yeah. It is delicate because basically what happens when you get these scholarships that are taxable from 1098-T, the child now has a level of unearned income from it. And unearned income typically is subject to kiddie tax, once it goes beyond a certain level. So that level is now $2,200.
Scott : [00:07:48] The income is counted towards the student and not the parent. Is that correct?
Ian: [00:07:54] It's counted towards the student.
Ian: [00:07:56] But when you have unearned income, that income gets taxed in the form of the kiddie tax. Which now the rules have changed a lot. So they have changed it with the Trump Jobs Act in 2018. And then actually that didn't settle very well people. So they changed it back to where now any unearned income gets charged at the parent's top marginal tax rate.
Scott : [00:08:22] So at the trust tax rate is what you're referring to?
Ian: [00:08:26] Right. Well, they're not doing this trust tax rates anymore. That
Scott : [00:08:29] Right that was under Trump. Now back to the old rule.
Ian: [00:08:33] Correct.
Scott : [00:08:33] But still, nevertheless, there's this tax rate that's occurring and it's coming in at a decent rate. I mean, it's at the top end of their bracket because this is being added on top of their income.
Ian: [00:08:48] So if you have taxable scholarships above and beyond $2,200 then you're getting taxed on that at the highest marginal rate of your parent.
Ian: [00:08:57] There are some things that you can do to kind of offset that. And that's where some of the educational tax credits come in handy. The one that we typically suggest for most folks is the American Opportunity Tax Credit. And if there's income caps on that, but sometimes you can claim dependency for the child as well to get that.
Ian: [00:09:21] So if you can have some of those credits, offset some of your scholarships then it's fine.
Ian: [00:09:26] And then that way you don't get tax on it. Or at least minimize the taxes that you see.
Scott : [00:09:32] That's good stuff, Ian. I think clearly this is something that wasn't on my radar as an adviser. And I know you handle more of the college planning side of it for us, but certainly learned a good amount today from a mistake that I'm sure others are making. So I hope everybody here enjoyed today's episode. And are there any parting thoughts?
Ian: [00:09:59] Yeah, I would just say, you know, speak to your financial aid office. And even when you're fielding scholarship offers just keep that fact in the back of your mind because it's important.
Scott : [00:10:11] Thanks for tuning in. We'll be sure to be bringing you more great college planning content for those who are parents out there looking for good advice. And we'll see you around.