Tax-Free Student Aid vs. Education Credit

Your Guide to State, Local, Federal, Estate + International Taxation

The American Opportunity and Lifetime Learning tax credits were created to subsidize the cost of college education. Generally, the credits are based on qualified costs of education, namely, college tuition and fees, books, supplies and equipment. Those qualified costs must be reduced, however, by the amount of any tax-free student aid received, such as scholarships and grants.

Student aid is not always tax free, however. That money is treated as taxable income when not spent on qualified education expenses. This can happen when the student aid may also be spent on housing, food, or other costs.

To the extent that scholarship or grant money can be spent on either qualified education costs or non-qualified costs, a student (or a parent who takes the student’s personal exemption on their tax return) may find that their federal income tax may be less by choosing to treat the student aid as taxable income (to the student), when that would result in a larger education credit.

For example, let’s consider the situation of a 24-year old student in their 4th year of college who has a part-time job, earning $15,000 for the year. The student receives a Form 1098-T from the college, reporting tuition of $6,000 in box 2 and a government grant of $6,000 in box 5. For the sake of this example, no other qualified education costs were incurred.

From one point of view, the entire tuition cost is off-set by the tax-free student aid. As a result, no education cost remains eligible for the American Opportunity Credit. The student’s federal income tax would be $503, based on the earned income in excess of the standard deduction and the personal exemption.

But, by an alternative point of view, treating $4,000 of the student aid as taxable income, $4,000 of the tuition would be eligible for education credit purposes. Before consideration of the credit, the student’s federal income tax would increase from $503 to $908, due to the inclusion of $4,000 of the grant in taxable income. Then, by application of the American Opportunity Credit, the tuition of $4,000 generates a $2,500 tax credit, $1,000 of which would be refundable in this situation. Filing the tax return in this manner, not only does the education credit reduce the student’s income tax to zero, but the student will receive a $1,000 tax refund.

By Stephen Kimball, CPA