Costs to attend some> colleges are approaching astronomical levels. For top-rated private universities, the annual hit can be $50,000 or higher. Some public schools charge out-of-state students $35,000 or more.
Fortunately, a surprisingly high percentage of students at many schools receive at least some financial aid, and your child's chances may be better than you think. So if your child cashes in, what are the tax implications? Here's what you need to know.
How financial aid benefits are treated for tax purposes is determined by the type aid your child receives.
Gift aid, or free money that the student doesn't have to work for, is often tax-free. Gift aid may be called a "scholarship," "fellowship," or "grant."
Arrangements where the student is required to work in exchange for money are also sometimes called "scholarships" or "fellowships," but that's a misnomer. Whatever payments for work may be called, they are considered compensation from employment and must be reported as income on the student's tax return.
Finally, the IRS doesn't care whether financial aid comes from a government agency, a nonprofit or a for-profit corporation. The tax consequences of financial aid benefits depend only on their economic nature not their source.
Most Gift Aid Is Tax-Free
Free-money scholarships, fellowships, and grants are generally awarded based on either financial need (for example, federal Pell grants) or academic merit (for example, National Merit Scholarships). Such gift aid is not taxable as long as:
1. The recipient is a degree candidate, including a graduate degree candidate.
2. The funds are designated for tuition and related expenses (including books and supplies), or they are unrestricted and are not specifically designated for some other purpose like room and board.
3. The recipient can show that tuition and related expenses equaled or exceeded the financial aid benefits. To pass this test, the student simply must incur enough of those expenses within the time frame for which the aid is awarded.
If gift aid exceeds tuition and related expenses, the excess is taxable income to the student.
Ditto for Tuition Discounts
Gift aid that comes directly from the university is often called a "tuition discount," "tuition reduction," or "university grant." These free-money awards fall under same tax rules that apply to free-money scholarships, fellowships and grants.
Example: Fred hits the financial aid jackpot and receives a completely free ride for his first year of college, which began in August 2010 and ends in May 2011. He collects scholarships, grants and tuition discounts totaling $40,000 for the academic year (the first semester of which is in 2010 and the second semester of which is in 2011). Fred's tuition and related expenses for the academic year total $30,000. The remaining $10,000 is intended to cover room and board and incidentals. The $10,000 is taxable income and must be reported on Fred's Form 1040. Because half of the $10,000 pertains to the first semester in 2010, Fred should report $5,000 on his 2010 return. The remaining $5,000 is for the second semester in 2011 and should be reported on his 2011 return.
Payments for Work Are Taxable
Under college work-study programs, students are given jobs to help finance their expenses. Work-study earnings count as taxable wages for federal income tax purposes. However, this doesn't necessarily mean the student will actually owe any tax (more on this later).
Sometimes, financial aid that is described as a "scholarship," "fellowship," "grant," or "tuition reduction" is actually contingent on the student providing services to the school (teaching, research or whatever). Such payments are taxable compensation.
It's not the student's problem to figure out how much is taxable in these situations. The financial aid payer should determine the taxable amount and report it to the student on Form W-2 or Form 1099-MISC.
Taxable Income Doesn't Necessarily Trigger Taxes
Receiving taxable financial aid doesn't necessarily mean owing anything to the IRS. Here's why. A student who is not a dependent can offset taxable income with his personal exemption $3,650 for 2010; $3,700 for 2011 and his standard deduction $5,700 for 2010; $5,800 for 2011 (assuming the student is unmarried). So a non-dependent student would not owe any federal income tax if his income from taxable sources was $9,350 or less for 2010 ($3,650 + $5,700 = $9,350) or $9,500 or less for 2011 ($3,700 + $5,800 = $9,500).
If your child is still your dependent, he is not entitled to a personal exemption deduction (you claim it on your return). But the child's standard deduction will still shelter up to $5,700 of 2010 earned income or up to $5,800 of 2011 earned income from federal income tax.
Taxable financial aid in excess of what can be offset by the student's personal exemption (if any) and standard deduction will probably be taxed at only a 10% rate. For 2010, an unmarried non-dependent student can have taxable gross income of up to $17,725 and still be in the 10% bracket; for 2011, the number rises to $18,000. Any additional income will probably be taxed at only a 15% rate.
Finally, if you don't claim your child a dependent on your return, he or she can probably reduce or eliminate any federal income tax bill by claiming the American Opportunity tax credit (worth up to $2,500) or the Lifetime Learning tax credit (worth up to $2,000).