My daughter got a scholarship. How can she avoid taxes?

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Q. My daughter got a college scholarship and part will be taxable. She also has some income, maybe $4,000, from a part-time job. Can she take any college credits or deductions? We claim her as a dependent.
— Dad

A. Congratulations on the scholarship.

There are many issues that could come into play here.

First, scholarships in general are tax-free if they are for qualified education expenses, said Laurie Wolfe, a certified financial planner and certified public accountant with Lassus Wherley, a subsidiary of Peapack-Gladstone Bank, in New Providence.

“Qualified expenses include tuition, fees and course-related expenses, such as fees, books, supplies and equipment that are required,” she said. “They do not include room and board, travel, research, clerical help or other equipment and expenses that aren’t required for enrollment.”

Additionally, scholarship money that represents compensation for teaching or other services provided by the student are not tax-free, Wolfe said.

If you have qualified education expenses over and above the tax-free scholarship, there are two education credits available: the American Opportunity Credit (AOC) and the Lifetime Learning Credit.

Subject to some eligibility rules, the American Opportunity Credit can be taken for four years of post-secondary school studies at an eligible institution, she said.

“The maximum eligible expense that can be taken into consideration is $4,000, which results in a tax credit of $2,500, 40 percent of which is potentially refundable,” she said.

The Lifetime Learning Credit is available in the pursuit of higher education at an eligible institution. There is no limit to the number of years that you can claim this credit, Wolfe said.

“The credit is 20 percent of the amount spent on eligible expenses up to $10,000, for a maximum credit of $2,000,” she said.

Like tax-free scholarships, eligible expenses for both credits include tuition, fees and books and supplies required for the courses taken.

“The amount of eligible expenses for purposes of the credits is reduced by any tax-free scholarships received,” Wolfe said. “This prevents receiving a double benefit for the same expense.”

Also note there is no longer a deduction for tuition and fees beginning with the 2018 tax year.

We’re going to focus on the American Opportunity Credit (AOC) as our example here.

Wolfe said the short answer to your question is that your daughter would be able to benefit from an education credit if her taxable income results in a tax liability and you do not claim her as a dependent on your tax return.

“If the wages from her part-time job are $4,000, she would have to have more than $8,200 in taxable scholarship – or other income – for her to be subject to any tax at all,” Wolfe said. “This is because the 2019 standard deduction available to an unmarried dependent is equal to the lesser of his/her earned income or $12,200.”

The taxable part of the scholarship is reported on the wage line of the 1040 and is considered earned income for purposes of applying the standard deduction, she said.

So, let’s look at your specific situation and make some assumptions. Let’s assume that your daughter is going into her first year of college and received a scholarship to Princeton University in the amount of $30,000, $14,000 of which is considered taxable. The balance, $16,000, represents a tax-free scholarship for tuition and fees.

If we assume that tuition/fees/books for the semester are $29,000, you would have over the maximum amount of expenses that will be considered for the AOC, $4,000 – $29,000 minus the $16,000 tax-free scholarship equals $13,000, Wolfe said.

“The education credit is limited to the actual tax calculated on your daughter’s income of $14,000 in taxable scholarship and $4,000 in earnings from odd jobs,” she said. “Your daughter’s tax in this case would be $1,625 and her AOC will be limited to this amount, resulting in a net tax liability of zero. Effectively, the entire scholarship would be tax-free.”

Now on the refundable portion of the AOC credit – 40 percent.

This means that the taxpayer would get a refund of that amount regardless of whether they had any tax liability at all, Wolfe said. However, the credit is not refundable to a person that could be claimed as a dependent on the tax return of another, even if that person opts not to claim her.

Another thing to consider is that the education credit can be claimed by the student or the parent of a dependent student, Wolfe said. You will need to compare who will receive the larger benefit to determine whether you should claim the credit on your own tax return or whether your daughter should take the credit.

“If your daughter claims the credit you must forgo claiming her as a dependent on your return for the year in question,” she said. “There are also income limitations that may prevent you from claiming the credit.”

In the Princeton case discussed above, your daughter received a tax credit of $1,625, but you likely lost the $500 child tax credit for dependents over 17 years of age by not claiming her as a dependent.

“The net benefit in this case then would be $1,125,” she said. “If you are eligible to claim the full AOC tax credit and the $500 child tax credit, your combined credits would amount to $3,000. Your daughter would pay $1,625 in taxes, but the net benefit – $1,375 – is higher than if your daughter had claimed the credit.”

Wolfe said other complex strategies could come into play if your child receives a full scholarship that leaves little or no eligible expenses with which to claim the credit. In this case, the child could elect to include some of their tax-free scholarship in her income for the year.

“Because the amount is now not considered tax-free, it will not reduce eligible expenses,” she said. “And remember, in your daughter’s case, she could have up to $8,200 more of taxable income before she incurs any actual tax at all.”

Lastly, an important item to mention is that although your taxable scholarship for things like room and board are reported on the wage line on the tax return, it is treated as unearned income for the tax calculation, Wolfe said.

Prior to the 2017 Tax Cut and Jobs Act, unearned income for children that are dependents was taxed at their parents’ marginal tax rate – the kiddie tax. This law changed the tax calculation from the parents’ rates to the rate used for trusts and estates.

These rates reach higher tax brackets at much lower income levels, Wolfe said.

“Taxable income over $2,600 is taxed at $24 percent, income over $9,300 is taxed at 35 percent and income over $12,750 is taxed at 37 percent – very harsh!” she said. “Treating taxable scholarships as unearned income could also subject dependents to the Alternative Minimum Tax.”

A bill introduced in May would correct this treatment and this income would be treated as earned income and taxed at the child’s individual income tax rate, Wolfe said. The hope is that this change would be retroactive so that individuals could amend their 2018 tax returns to get a refund if they were affected by these rules.

Given the complexities of all this, we highly recommend you work with a tax professional to see what scenario is most beneficial for you and your daughter.

Email your questions to moc.p1571554763leHye1571554763noMJN1571554763@ksA1571554763.

This story was originally published on Aug. 8, 2019.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.