COLLEGE SAVINGS 101

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A tax strategy that will surprise you
http://www.savingforcollege.com/articles/a-tax-strategy-that-will-surprise-you-648

Updated: 2016-10-05 by Brian Boswell

by Joseph Hurley

Financial Professional Content

Many college students receive scholarships of one sort or another when they go off to college. The nice thing about scholarships, other than reducing the cost of college, is that they are generally tax-free when used to pay tuition and fees, or when used to pay for books, supplies, and equipment required by the curriculum.

What most people don't know is that students are sometimes better off claiming their scholarship as taxable income, if permitted to do so. Special considerations come into play for families with 529 plans.

Here's how it works.

The American Opportunity Tax Credit is a valuable tax incentive for those who qualify:

  • The first $2,000 of tuition and related expenses comes back dollar-for-dollar as a tax credit.
  • Of the next $2,000 of eligible expenses, 25% comes back as a tax credit.

That's a maximum credit of $2,500 on $4,000 in eligible expenses. Up to 40% of the credit is refundable for qualifying taxpayers with zero tax liability.

RELATED: Ask an expert: Can I use 529 plan funds to pay for college and get the American Opportunity Tax Credit?

However, some parents may not be able to claim the credit due to the income phase-outs if their income is too high. So instead, they may find it beneficial to push the credit onto the student's tax return. Be careful, though, as a student receiving a tax-free scholarship must reduce tax-credit expenses by the scholarship amount. In some situations, this will actually increase the overall tax burden.

The solution in these situations is to claim the scholarship, or some portion of it, as taxable income. If the student is allowed to use the scholarship for room and board, transportation, or other non-qualifying expenses, doing so will create taxable income and avoid the downward adjustment to the American Opportunity Tax Credit.

This strategy will also increase the pool of qualified higher education expenses for purposes of withdrawing funds tax-free from a 529 plan. However, that won't usually provide a net tax benefit even if it means avoiding a non-qualified withdrawal from the 529 plan. Remember: the 10% penalty is not assessed under either treatment, since the penalty is waived on non-qualified withdrawals attributable to scholarships.

Taxes are complicated, and many of the complications of this particular strategy, including eligibility rules and tax dependency issues, have not been described in this column. Publication 970 from the IRS is most helpful. Your clients should also consult with a qualified tax professional.

Originally posted 2014-07-23

Financial Professional Content

Many college students receive scholarships of one sort or another when they go off to college. The nice thing about scholarships, other than reducing the cost of college, is that they are generally tax-free when used to pay tuition and fees, or when used to pay for books, supplies, and equipment required by the curriculum.

What most people don't know is that students are sometimes better off claiming their scholarship as taxable income, if permitted to do so. Special considerations come into play for families with 529 plans.

Here's how it works.

The American Opportunity Tax Credit is a valuable tax incentive for those who qualify:

  • The first $2,000 of tuition and related expenses comes back dollar-for-dollar as a tax credit.
  • Of the next $2,000 of eligible expenses, 25% comes back as a tax credit.

That's a maximum credit of $2,500 on $4,000 in eligible expenses. Up to 40% of the credit is refundable for qualifying taxpayers with zero tax liability.

RELATED: Ask an expert: Can I use 529 plan funds to pay for college and get the American Opportunity Tax Credit?

However, some parents may not be able to claim the credit due to the income phase-outs if their income is too high. So instead, they may find it beneficial to push the credit onto the student's tax return. Be careful, though, as a student receiving a tax-free scholarship must reduce tax-credit expenses by the scholarship amount. In some situations, this will actually increase the overall tax burden.

The solution in these situations is to claim the scholarship, or some portion of it, as taxable income. If the student is allowed to use the scholarship for room and board, transportation, or other non-qualifying expenses, doing so will create taxable income and avoid the downward adjustment to the American Opportunity Tax Credit.

This strategy will also increase the pool of qualified higher education expenses for purposes of withdrawing funds tax-free from a 529 plan. However, that won't usually provide a net tax benefit even if it means avoiding a non-qualified withdrawal from the 529 plan. Remember: the 10% penalty is not assessed under either treatment, since the penalty is waived on non-qualified withdrawals attributable to scholarships.

Taxes are complicated, and many of the complications of this particular strategy, including eligibility rules and tax dependency issues, have not been described in this column. Publication 970 from the IRS is most helpful. Your clients should also consult with a qualified tax professional.

Originally posted 2014-07-23

 

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