How to choose between a tax-free scholarship and education credits
What’s better than a tax-free scholarship? Sometimes, an education tax credit could be, like the American Opportunity Credit. Students (or the student’s parents if they claim the student as a dependent) can’t “double-dip” by claiming more than one benefit for the same expenses. But they may be able to choose the benefit that best fits their situation. At times, paying income taxes on nontaxable scholarship money can give them a better tax break than they would receive by taking the scholarship money tax-free.
Tax-free scholarship vs. a tax credit for education expenses
Whether a scholarship is tax-free depends on what restrictions it imposes. Scholarships restricted to tuition, fees, books, supplies or required equipment are tax-free. Students will not have to pay income tax on these scholarships. For example, a student with an effective tax rate of 10 percent could save up to $1,000 with this tax-free benefit.
The American Opportunity Credit also covers tuition, fees and course materials like textbooks. Students or their parents can receive up to $2,500 for $4,000 in these expenses. For example, a family that pays $10,000 in tuition could get the maximum $2,500 credit on the parents’ tax return.
No double-dipping allowed
Students cannot pay their tuition with a tax-free scholarship and then claim that amount as an eligible expense toward the American Opportunity Credit. For example, if the student had both a $10,000 scholarship and $10,000 in tuition, they can’t “double-dip” and get the $2,500 credit on the parents’ tax return and have $10,000 excluded from the student’s income. They may only use one benefit for the same expense.
Tax planning encouraged
Students with an unrestricted scholarship have more options to maximize their tax benefit. By using the scholarship to pay for nonqualified expenses and paying taxes on their scholarship, they could become eligible for the American Opportunity Credit.
For example, a student with a $10,000 restricted scholarship, $10,000 in tuition and $4,000 in room and board cannot get a tax credit. The student’s only tax benefit would be excluding the $10,000 scholarship from income for tax purposes. The parents would not derive any additional tax benefit.
If the student instead had an unrestricted scholarship, the student could allocate $4,000 of the scholarship to their room and board and pay $4,000 in tuition from their own resources. The $4,000 they spend toward tuition would make the parents eligible for the maximum tax credit of $2,500. The student would also get the remaining $6,000 of the scholarship tax-free.
If the student was in the 10 percent tax bracket, the student would pay $400 on the $4,000 of scholarship money that went toward room and board. Combined with the $2,500 tax credit and tax-free part of the scholarship, their total tax benefit increases to $2,700. This is more than $1,700 extra than if they had taken the entire scholarship tax-free.
The bottom line: a $2,500 education tax credit can be greater than tax on $4,000
In most cases, the credit taxpayers could get would be greater than the tax paid on an unrestricted scholarship. So, a student or their family could maximize their tax savings if they have less than $4,000 in eligible expenses and can use an unrestricted scholarship toward nonqualified expenses.
Students, along with their parents, could have some tricky tax situations to navigate. Do scholarship terms allow recipients to choose to use funds for tuition, books or nonqualified expenses (such as room and board)? Who is best served (the student or the family) by claiming the credit? Are there “kiddie tax” or Alternative Minimum Tax (AMT) complications from paying tax on an otherwise tax-free scholarship? In each case, students should make sure their tax-free scholarship is really the best deal. They may find that paying the tax man puts more money back in their college account.