What tax rate is charged to taxable scholarships

[newpreparer25]

My son has taxable scholarships and also works.  We claim him as a dependent but the scholarship is greater than qualified expenses.  He was working before the scholarship were awarded and expected to earn less than 10,000 so no federal taxes were withheld and only a small amount for state. Scholarships used for unqualfied expenses was around 10,000.  Should he be taxed just based on his income (earned and unearned-the scholarship) or will the tax rate be based on the parent's income tax rate?

It just seems high?

[Hal_Al]

The parent's marginal tax rate will be applied to most of the taxable scholarship (the so called "kiddie tax"). About $4600 will not be taxed at all, because of the increased standard deduction. 

Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $14,600 filing requirement (2024) and the dependent standard deduction calculation (earned income + $450).  It is not earned income for the kiddie tax and other purposes (e.g. EIC).  For grad students and post grad fellows, scholarship, stipend and fellowship income is earned income ("compensation") for IRA contributions.

You might want to consider having him pay even more tax:

  There is a tax “loop hole” available to claim an education credit, for the parents of students on scholarship. The student reports all his scholarship, up to the amount needed to claim the American Opportunity Credit (AOC), as income on his return. That way, the parents  (or himself, if he is not a dependent) can claim the tuition credit on their return. They can do this because that much tuition was no longer paid by "tax free" scholarship.  You cannot do this  if the conditions of the grant are that it be used to pay for qualified expenses.

Using an example: Student has $10,000 in box 5 of the 1098-T and $8000 in box 1. At first glance he/she has $2000 of taxable income and nobody can claim the American opportunity credit. But if she reports $6000 as income on her return, the parents can claim $4000* of qualified expenses on their return.

Books and computers are also qualifying expenses for the AOC. So, extending the example, the student had another $1000 in expenses for those course materials, paid out of pocket. She would only need to report $5000 of taxable scholarship income, instead of $6000.

Taxable scholarship goes on line 8r of Schedule 1.

*The AOC is 100% of the first $2000 of tuition and 25% of the 2nd $2000.  Declaring only $2000 more scholarship (instead of $4000) might be an alternate option; usually not. 

[DaveF1006]

It depends. If you are filing a kiddie tax return on your return, the tax rate is mostly based on your marginal tax rate and not your child's. 

Under this arrangement, the first $1300 is tax free. The next $1300 is charged at the child's tax rate. The remainder will be subject to your tax rate.

If your son files his own return and states that he can be a dependent of some one else, he will be paying on his own marginal tax rate.

Kiddie Tax Explained

[newpreparer25]

If we claim him as a dependent we get the other dependent credit.  So would it be better to claim him as a dependent?

[DaveF1006]

Yes. I agree with Hal_Al post. I may add that your son can file his own return, indicate he can be claimed by someone else, and then be taxed on his lower marginal tax rate. This is just a suggestion you might consider.

[Hal_Al]

Q.  So would it be better to NOT claim him as a dependent?

A. No. Not claiming him as a dependent would not eliminate the kiddie tax.  It's based on age, student status and source of support, not dependent status.

[Hal_Al]

I edited my 2nd reply (I left out "NOT").

[newpreparer25]

Tried that and the system is asking for parents information and taxable income.  It looks like the tax rate being used is a blended rate that is around 22%.  His tax rate should be no more than 12% given the total of his earned income and the taxable scholarship.  That is why I thought it was high.  (This is his return)  with suggested item selected.  

[Hal_Al]

"Your son can file his own return, indicate he can be claimed by someone else, and then be taxed on his lower marginal tax rate"

That statement is only correct is the student has all earned income*.  At $14,600 total income the taxable scholarship turns into  unearned income.   There is no avoiding the kiddie tax, in your situation. 

*He gets the full $14,600 standard deduction. But, the first $10,000 is allocated to his $10K wage income. The first $4600 of the scholarship income is covered by the rest of the standard deduction. The $5400 taxable income ($10K wages + $10K scholarship - $14,600 std deduction = $5400 taxable income) is all considered unearned income. None of the $5400 is taxed at his rate.

When does he get taxed at his rate? It may be best explained by example.  What if he had $15K wages, instead of $10K. $15K wages + $10K scholarship - $14,600 std deduction = $10,400 taxable income.  Only $400 would be taxed at his marginal rate (10% not 12%), the rest would be subject to the kiddie tax, as unearned income.