Kids Going to College – Better Have a Tax Plan

irs tax help 1

Finally ….. your son or daughter is off to college, a whole new stage of life begins. As the celebration fades and classes begin it’s time to start thinking about the tax planning and taking full advantage of all of your benefits and avoiding unnecessary tax burdens. It’s it just great that your loved one has received a huge scholarship and you have been socking money away in a 529 fund. Well you need to also understand there can be a tax consequence involved if you aren’t careful.

FACT: Scholarship amounts that exceed “qualified education expenses” are taxable as ordinary income and furthermore require the payment of “self-employment” tax to the person receiving the 1098-T, the student.

FACT: If the scholarship amount reduces your out of pocket costs of college it would interfere with you taking advantage of a huge tax break.

During the 2017 tax season (ending in April 2018) I saw a number of 1098-T (tax statements from college) that showed substantially more “Scholarship” income than Qualified Expenses. Somebody is paying tax on this income! Another example is scholarship or fellowship money that represents compensation, say a $20,000 teaching assistant fellowship went primarily to pay for tuition and books, that $20,000 would still be considered taxable income! Even if the scholarship amount is substantial, you could miss out on your tax break.

But there is some good news here also, beyond having your kid in college. There are various tax breaks including, if you qualify, the American Opportunity Tax Credit (AOTC). The AOTC can be worth up to $2,500 per undergraduate every year for 4 years, that’s $10,000 over 4 years. There are some income limits and the credit gets phased out as your modified adjusted gross income rises.  Different college-related credits and deductions have different rules, so it pays to look into which will work best for you.

The AOTC is calculated as 100% of the 1st $2,000 in qualified expenses and 25% of the next $2,000. So $4,000 is the maximum “qualified expenses” that apply. 

So, since you as a parent still claim the student as a dependent (you pay more than ½ of his/her total expenses) YOU can claim the AOTC on YOUR taxes! Kids away at college are deemed to be “temporarily gone” but still living with you. 

HOWEVER … if you scholarship income is more than the “qualified expenses”, there are no real “expenses” and therefore you, the parent won’t get the $2,500 American Opportunity Tax Credit.

So, there is a legal way around this that may not be apparent to many taxpayers.

Here is what you do:
Have the parents claim tuition, up to a max of $4,000 to get the full AOTC, then show the scholarship income on the students tax return with the balance of the expenses. The assumption is that the student will be in a much lower tax bracket than the parent. The parent will get the $2,500 tax credit. This credit in a higher tax bracket is much better that the lower taxes paid by the student. You can do this every year. In addition, there is a portion of the AOTC that is “refundable in 2018, up to $1,000. This means that if your tax bill was only say $1,500 and you applied the $2,500 tax credit, you would have a $0 tax bill PLUS get a $1,000 refund.

Also keep in mind that you can’t double-dip if you have a 529 plan. Therefore, before you write that first tuition check: You can’t use the same qualified college expenses to calculate both your tax-free withdrawal from a 529 college savings plan and the AOTC tax break. In other words, if you pay the entire college bill with an untaxed 529 plan withdrawal, you probably won’t be eligible for any college tax credit or deductions.

You can check IRS Publication 970 for qualified education expenses. In addition if you pay qualified expenses from “tax-free” funds like Pell grants etc. you can’t use these expenses in your calculations for the credit.

See what I mean, you may need a tax plan if you have kids in college. You may also need professional tax help to develop a plan.


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