The rising cost of higher education has been on the minds of American families for a number of years and has even sparked recent Congressional investigations. As costs continue to climb and employers increasingly require a college degree for entry level work, students are looking everywhere for a way to defray some of those costs. There is some relief that students or parents may be able to obtain immediately though through applying for certain tax credits on their income tax returns. The American Opportunity Tax Credit ("AOTC") and Lifetime Learning Credit ("LLC") help offset some of the cost of tuition with an annual tax credit that reduces the amount of income tax due. However, because of certain complexities when it comes to Federal Pell Grant scholarships, the Department of the Treasury believes that hundreds of millions of dollars of credits are left unclaimed every year. The Treasury says these credits can be maximized with additional planning and calculation on the part of taxpayers.
The IRS attributes taxpayer's failure to take full advantage of tax credits like the AOTC and LLC to a misunderstanding of how Pell Grants and other similarly situated scholarships are treated under the tax code. The Pell Grant is a form of government aid for qualifying students and is unique in that it may be utilized to pay for (1) qualified tuition and related expenses ("QTRE"), (2) living expenses (such as room and board), or (3) a combination of the two. The taxpayer is permitted to choose how they allocate the Pell Grant regardless of how the qualifying institution chooses to allocate the grant money. The allocation is important for tax purposes because funds allocated to QTRE are excluded from taxable income, while funds allocated to living expenses are treated as taxable income.
At first glance, it would seem that all funds should be allocated to QTRE in an effort to reduce taxable income, but this is where most taxpayers with Pell Grants make their mistake. If the student elects not to pay income taxes on the Pell Grant, through treating the scholarship as QTRE, the amount of QTRE used to calculate the AOTC and LLC must be reduced in an amount equal to the grant or scholarship. This prevents the taxpayer from obtaining the maximum possible credit. Conversely, if the Pell Grant or scholarship is allocated only to living expenses, the student will pay taxes on that grant equal to their marginal tax rate, but would not have to reduce QTRE for credit calculation purposes and could maximize their allowable tax credit.
Through proper tax planning, taxpayers could potentially benefit from allocating a portion of their Pell Grants to living expenses. This would require they pay tax on the portion of income allocated, but would still permit them to claim the maximum credit possible under either the AOTC or LLC. Also the credit will offset any tax due as a result of an allocation of the grant to living expenses. The Treasury Department does warn, though, that tax-minimizing allocations depend on a number of factors including the terms of qualifying scholarships, the amount of scholarship and expenses, and the student's or parent’s marginal tax rate. The optimal strategy will be specific to each student and the calculation can be complex.
If you have any questions about achieving the maximum tax benefits from college expenditures, please contact us.