A question we see quite frequently as school starts is, “Is my child’s scholarship taxable?” As with most tax questions the answer is, “It depends.”
If a scholarship is used to pay for college tuition, fees, books, or required equipment, it is not taxable; however, if the scholarship is used to cover room and board, travel costs, or optional equipment, then it is taxable. The scholarship is also taxable if it is awarded as payment for teaching, research or some other required service.
With most scholarships, the recipient can decide how to apply the money. While your first instinct may be to apply it to tuition, fees, or books, thus making it tax free, this choice may impact your ability to claim the Lifetime Learning or the American Opportunity (formerly the Hope) tax credits. These credits are based on the amount of qualified tuition and fees paid. Therefore, if tuition and fees are paid in-part or in-full by a scholarship, you personally will have paid less when calculating your credit. Tax credits generally reduce your taxes dollar for dollar, so this could be a substantial savings.
This scenario has the most impact on your ability to claim the Lifetime Learning credit, calculated as 20% of the first $10,000 of tuition and fees up to $2,000. For example, if you receive a large scholarship and apply it to these expenses, you may be left with less than $10,000 in eligible tuition and fees to count toward the credit.
The American Opportunity credit is calculated differently—100% of the first $2,000 of tuition and fees, plus 25% of the next $2,000 of such expenses, up to $2,500. You may take either the American Opportunity or the Lifetime Learning credit in a given year for the same student, so if you have two students in college, you may want to weigh your options by consulting a tax adviser. Additionally, both credits have different income phase-out levels, so it is advisable to discuss your specific situation with a tax expert.
If the scholarship has no restrictions on how it can be applied, and you fall within the income limits to take the credits, consider calculating tax projections to determine your best option. First, try applying the scholarship to tuition and then reduce the amount of eligible tuition that can be used to calculate the tax credits. Second, try applying the scholarship to room and board, paying income tax on the scholarship, but allowing all tuition to be counted when calculating the credits.
Calculating credits and determining how best to apply a scholarship can be difficult, even if you have a relatively simple tax return. However, the savings from taking advantage of federal tax credits—up to $2,500 in some cases—may make it worth your time to talk to your tax expert. A C.P.A. can help you and your family look at the different scenarios and make suggestions to save you money during your child’s college years.