Last year the IRS
published a Fact Sheet
explaining that the complex interaction of scholarships and Pell Grants with
the American Opportunity Tax Credit (AOTC) may be causing students to miss out
on refundable tax credits. The AOTC is
available for qualified tuition, fees, and course materials (qualified expenses
or QE’s) of the first four years of higher education. The AOTC is equal to 100% of the first $2,000
of QE’s paid plus 25% of the next $2,000 of QE’s, for a total maximum credit of
$2,500. The main point to note is
that 40% of the AOTC ($1,000 maximum) is a refundable credit, meaning that the
IRS will pay you this portion of the credit even if you have no income tax to
offset the credit against.
The Pell grant
permits a student to choose whether to allocate the grant to QE’s or to living
expenses when filing an income tax return.
Many scholarships also permit this flexibility. But if the terms of the scholarship restrict
it to the payment of QE’s only, then an allocation cannot be made. Making the proper choice is key to
unlocking hundreds of dollars in refunds that might otherwise go unclaimed.
·
If the grant or
scholarship is allocated to QE’s, it makes the financial assistance nontaxable,
but it also reduces the amount of eligible college expenses available for the
AOTC.
·
Allocating the
grant or scholarship to living expenses such as room and board causes the
financial assistance to become taxable income, but it no longer reduces the
amount of QE’s necessary for the AOTC.
The student can make this allocation on his or her tax return even if
the educational institution applies the funds against tuition and fees. Most students are low income taxpayers, and
causing some of the grant or scholarship to become taxable often will not
increase the student’s income tax. If
tax is increased, the higher AOTC most often will more than cover the increased
tax.
Who should
consider this strategy? If the total amount of your QE’s minus your
grant and scholarship is less than $4,000; then you will not generate the
maximum AOTC without allocating a portion (it is not an all or nothing
allocation choice) to taxable living expenses.
On the other hand, if QE’s exceed total grants and scholarships by
$4,000 or more, you will generate the maximum AOTC without the need to allocate
a portion of the grant and scholarship to taxable living expenses.
Each person’s
situation is unique and this strategy should be carefully considered to determine
whether it is beneficial.
