Understanding the Proposed Taxation of Merit Scholarships: What Parents Need to Know

Guest Post Author: Foundry Senior Consultant, Maggie Martin

Like many families, I’m planning on taking my high school children on a few college tours this spring break. But looming over what should be a joyful experience is a proposed change in federal tax policy that could significantly impact college affordability. House Republicans are considering a proposal to tax all merit-based scholarships, including those used for tuition and fees, which are currently tax-exempt. This shift would increase the financial burden on students and families who rely on scholarships to fund higher education.

*Note: Currently, no official bill has been introduced, but it’s important to understand the potential ramifications should this occur.

Current Tax Treatment of Scholarships

Under existing IRS guidelines, scholarships and grants are tax-free if they are used for qualified education expenses, such as tuition, fees, books, and required supplies. However, funds used for non-qualified expenses like room and board, travel, or optional equipment are considered taxable income.

The Proposed Change

The new proposal aims to classify all scholarship and fellowship funds as taxable income, regardless of their use. This means that even scholarships applied directly to tuition would be subject to income tax. The change is part of broader efforts to extend tax cuts from the 2017 Tax Cuts and Jobs Act and would generate an estimated $54 billion in federal revenue over ten years.

Potential Impact on Families

According to the National Center for Education Statistics, in 2019-2020, 26% of in-state public college students and 16% of students enrolled in private, nonprofit institutions paid the sticker price. It is not a stretch to imagine those percentages have continued to decline, indicating that this proposed tax would significantly increase the cost of college for the vast majority of families. This added expense could be particularly burdensome for low- and middle-income families and may discourage students from pursuing higher education.

Case Study: What This Could Mean for Your Student

Here’s an example of how this could affect a student we’ll call Jane:

Jane receives a $30,000 merit scholarship annually to attend a private university where tuition is $50,000 per year.
Under current law, Jane’s scholarship is not taxed because it is used entirely for tuition.
Under the proposed change, the entire $30,000 would be treated as taxable income.

What could this mean for Jane financially?

If Jane is claimed as a dependent and has no other income, she would fall into the 12% federal income tax bracket.
That means she could owe approximately $2,400 in federal income taxes just for her scholarship.
Depending on her state’s tax laws, she may also owe state income tax — potentially bringing the total tax bill to $3,000 or more annually.

This is money Jane and her family would need to come up with out of pocket, despite already covering room, board, and other college expenses.

One thing to note here is that it is not yet clear if the tax will be based on the student’s tax bracket or the parents. If a student is a dependent (which most traditional college students are), the IRS may apply the Kiddie Tax rules. The Kiddie Tax was originally created to prevent high-income parents from shifting unearned income to their children to take advantage of lower tax brackets. Under the Kiddie Tax, unearned income (like taxable scholarships or investment income) above $2,600 (2025 threshold) may be taxed at the parent’s marginal tax rate, not the student’s. This means a student could pay tax at their parents’ much higher tax bracket, especially if the scholarship is considered "unearned income."

Let’s revisit Jane from the earlier case study:

$30,000 merit scholarship now fully taxable.
If considered unearned income, and Jane is a dependent, then:
- The first $1,300 (2025 threshold) would be tax-free.
- The next $1,300 taxed at Jane’s rate.
- Anything above $2,600 (~$27,400 in this case) could be taxed at her parents’ rate — possibly 22% or higher.

That would bring her federal tax bill to over $6,000, not counting state taxes.

Considerations for College Planning

As you develop your student's college list, consider the following:

Evaluate Financial Aid Packages: Understand the composition of financial aid offers, distinguishing between scholarships, grants, and loans.
Assess Total Cost of Attendance: Factor in potential tax liabilities when calculating the net cost of each college.
Consult a Tax Professional: Seek advice on how potential tax changes could affect your family's financial situation.
Advocate for Policy Awareness: Stay informed about legislative developments and consider reaching out to elected officials to express concerns.

Conclusion

The proposed taxation of merit scholarships represents a significant shift in education financing policy, with the potential to increase college costs for many families. Staying informed and proactive, making your thoughts clear to your representatives and considering this in financial planning is essential.