Dear Carrie,
My daughter was lucky enough to receive a significant college scholarship. Is this considered taxable income to her? And does her scholarship limit my ability to claim an education tax credit?
-- A Reader
Dear Reader,
First congratulations to your daughter -- and to you. Her scholarship can be a significant financial boost for both of you. This is a great question because it touches on issues that both students and parents need to be aware of when filing tax returns.
First, the good news for your daughter is that scholarship money, for the most part, isn't taxable because it isn't considered income. The good news for you is that you still may be able to claim an education tax credit on your return as long as you pay qualified expenses above and beyond what your daughter's scholarship covers.
Of course, when it comes to taxes, there's rarely a simple yes or no answer. So before you start celebrating, let's look closer at each situation.
Scholarships that are tax-free
According to the IRS, certain conditions must be met for a scholarship or fellowship to be tax-free:
- The student must be a degree candidate at an eligible educational institution, which generally means an institution with a regular faculty, curriculum and enrolled body of students.
- The scholarship or fellowship money is used for qualified expenses. This includes tuition and fees, books, and course -- or degree-related costs (like supplies required for specific classes). It does not include other college-related costs such as room, board and travel.
- The money does not represent wages for teaching or other work.
That sounds pretty clear. However, for a scholarship to be completely tax-free, all the money must be used for qualified expenses. For example, if your daughter received a $10,000 scholarship and tuition was $15,000, she wouldn't owe taxes. However, if her scholarship was $20,000 and $5000 went for room and board, that $5000 would be considered taxable income.
Scholarships considered taxable income
Now, let's say your daughter is a grad student with a fellowship that requires her to be a teaching assistant. In this case, the tax rules are different. That's because scholarship or fellowship money that represents compensation is taxable -- regardless of how the money is used. So, even if a $20,000 teaching assistant fellowship went primarily to pay for tuition and books, that $20,000 would still be considered taxable income. The student would receive a W-2 from the school and would have to file a tax return.
A couple of exceptions
These IRS rules apply to scholarships (both merit and athletic), fellowships and grants -- including government-sponsored, need-based Pell Grants. However, there are exceptions.
For example, payments made through the GI Bill aren't considered scholarships, nor are they considered taxable income. Students participating in the National Health Service Corps Scholarship Program or the Armed Forces Health Professions Scholarship and Financial Assistance Program also don't pay taxes on their aid. Student loans, of course, are never taxable since they aren't considered income, and have to be repaid.
And just to be very clear, scholarships awarded to students who are not in a degree program are always taxable.
How education tax credits fit in
Education tax credits -- which directly reduce the amount of income tax you pay -- could be another way to offset some of your daughter's qualified college expenses, depending on your own income. There are two possible credits available:
- American Opportunity Tax Credit (AOTC) -- This credit, currently available through 2017, allows an annual maximum credit of $2500 per student for four years of undergraduate education. To qualify for the full credit, your modified adjusted gross income (MAGI) must be $80,000 or less ($160,000 or less for married filing jointly). The credit is phased out for taxpayers with incomes above these levels.
- The Lifetime Learning Credit (LLC) -- This credit allows a maximum of $2000 per year per tax return (not per student), but it can apply to undergraduate, graduate or professional degree courses, with no limit on the number of years. Income limitations are lower: MAGI must be $55,000 or less for individuals ($110,000 or less for married filing jointly).
If you qualify for both credits, you must choose one or the other. There's no double dipping.
Don't forget deductions
A tax deduction reduces your taxable income. There are two deductions that may apply to your situation. One is the tuition and fees deduction, which allows you to deduct qualified higher education expenses of up to $4000 paid during the year for yourself, your spouse or your dependent. The income limitation for this deduction is the same as that for the AOTC mentioned above.
Another deduction to be aware of is the student loan interest deduction of up to $2500, available with an MAGI of less than $65,000 ($130,000 if filing a joint return).
Get the full details
This is just the topline information, but it should give you a good start. To make sure your situation falls within all the IRS parameters, go to irs.gov/uac/Tax-Benefits-for-Education:-Information-Center or consult IRS Publication 970: Tax Benefits for Education. Better yet, talk to your accountant or other tax professional. And best of luck to your daughter.
Looking for answers to your retirement questions? Check out Carrie's new book, "The Charles Schwab Guide to Finances After Fifty: Answers to Your Most Important Money Questions."
This article originally appeared on Schwab.com. You can e-mail Carrie at askcarrie@schwab.com, or click here for additional Ask Carrie columns. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.
COPYRIGHT 2015 CHARLES SCHWAB & CO., INC. (MEMBER SIPC.) (0215-0299)