It’s that time of year again. Time to strategize and plan on using tax breaks to assist with your education. In our earlier articles, we provided details on the taxation of different kinds of federal financial aids available to U.S. students. Along with this, we also highlighted various tax credits claimable by U.S. students, such as: American Opportunity Tax Credit (AOTC), and Lifetime Learning Credit (LLC).
There are various federal grants and scholarships that may be used for living expenses while studying and/or for paying for books and tuition, and depending on the type of expenses and taxable income, the student or their parent taxpayer may claim the education tax credits for which they qualify.
It is important to properly plan how these financial aids will be allocated to maximize the tax claims for education expenses, and tax credits, since at times letting go of certain credits or using the financial aid for only one particular expense, could be more beneficial tax-wise than claiming every credit that one qualifies for.
In this article, we will discuss education tax credits and financial aids, such as scholarship income, and how to claim them in a tax-effective manner.
U.S. Tax Strategy for Education Credits & Financial Aids
Financial Aids Overview – Education Grants & Scholarship
The most common Federal grant is the Pell Grant. A Pell Grant is a subsidy the U.S. federal government provides for students who need it to pay for college. Federal Pell Grants are limited to students with financial need, who have not earned their first bachelor’s degree, or who are enrolled in certain post-baccalaureate programs, through participating institutions. The maximum Federal Pell Grant for the 2018–19 award year (July 1, 2018, through June 30, 2019) is expected to be $6,095.
Pell Grants and other similar federal financial aids (including scholarships) for education may be allocated either towards tuition fees, other education-related expenses or towards the living expenses incurred during the study period. The usage of these funds determine the taxation of the financial aid. That is, if the fund is used for paying tuition fees and other education expenses it is non-taxable, but if it is used for living expenses then the financial aid is treated as ‘taxable income’. If it is partially used for education fees and partly for living expenses, then only the portion used to pay for living expenses is subject to taxes.
The student has the right to choose whether to allocate the fund toward tuition fees and course related expenses or living expense when they file their tax return irrespective of how the school applies the scholarship.
This allocation of fund in the right manner is absolutely necessary as it impacts the total amount used to calculate the taxable portion of the scholarship as well as the education-related tax credits the student or their parent can claim.
Education Tax Credits Overview
There are various tax credits which students can use to reduce their tax liability.
The American Opportunity Tax Credit (AOTC) is available to students in the first four years of their post-secondary education to offset qualifying tuition and related expenses. The student can claim 100% of the first $2,000 of these expenses and 25% of the next $2,000 expense, i.e. $500. Therefore, a total of $2,500 of qualifying education and related expenses can be claimed under AOTC, of which $1,000 is a refundable tax credit.
If the student does not qualify for AOTC, he/she can claim ‘Lifetime Learning Credit’ (LLC) to claim qualifying post-secondary education expenses. The Lifetime Learning Credit is a non-refundable tax credit equal to 20% of up to $10,000 of the qualifying education expenses, i.e. $2,000.
The Dilemma – Tuition Fees or Living Expenses Through Financial Aid
Based on the above information, the student can either claim the entire Pell Grant and other scholarships as a tax-free scholarship if used to pay tuition fees, or direct the grant money toward living expenses and claim credits for the qualifying tuition fees, or divide the expenses strategically to benefit from both: non-taxable income and refundable & non-refundable education tax credits.
If the student chooses the first option, the scholarship income will not be taxable but if a grant or scholarship is allocated to qualifying education expenses, these expenses are subtracted from the eligible expenses for which AOTC or LLC can be claimed. Choosing the second option will result in the grant money being subject to tax and increasing the amount of AOTC or LLC that the student may claim.
Therefore, it may seem appropriate to follow the third option which allows the student to benefit from non-taxable income and tax credit. For example, if the student qualifies for the AOTC, the maximum claim is based on $4,000 of eligible expenses. If the student’s scholarship minus the qualifying expenses is less than $4,000 the student may wish to include some of the scholarship in income in order to maximize the AOTC.
The allocation between qualifying education expenses and living expenses is complex and will depend on a number of factors. The calculation of the optimal strategy is especially complicated because in the case of a dependent student it may depend on two tax returns and because a student’s marginal tax rate may change depending on how much of the scholarship is included in income. The optimal strategy is specific to each student’s situation.
IRS Tax Laws Related To Education Expenses
In summary, the federal tax laws related to claiming education expenses are:
- Scholarships, Pell Grants, and other financial aids received for education should be used for the purpose of education only.
- Scholarship amounts that are used for qualifying education expenses are considered ‘non-taxable’ income
- Qualified education expenses may be eligible for AOTC/LLC, and
- Scholarship funds used for living expenses during the four years of education can be claimed by the student or parent on their federal income tax return
- The student has the right to choose how to allocate the scholarship funds when filing his/her tax return regardless of how the educational institution allocated the funds.
Often students and their parents are not aware of these tax rules regarding scholarships, which results in them losing out on the tax credits. Additionally, arriving at the perfect ratio between education expenses to be claimed as tax credits versus non-taxable income is so complex that some taxpayers simply go with the easier option of claiming the grant benefit as non-taxable income which also results in losing the possible refundable tax credit.
As per expert analysis, almost 9 million students who receive Pell Grants do not file their tax return and forego the AOTC or LLC education tax credits resulting in millions of dollars of unclaimed credits every tax year.
Therefore, it is highly recommended that students or their parents consult tax professionals regarding the most beneficial way to claim these education expenses on the tax return, which could either reduce the tax burden or result in a refund scenario.
AG TAX LLP CAN HELP
If you have any tax-related queries, need assistance with tax planning or filing your tax returns please contact us. Our team comprises of highly experienced tax professionals with extensive knowledge of US and Canadian tax laws as well as cross-border compliance.
Furthermore, as a full service accounting firm, AG Tax assures complete assistance with even your most complex tax needs.
We can assist with:
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