By Bill Bischoff
Published: July 28, 2015 on MarketWatch

Costs to attend some colleges are approaching astronomical levels.

For top-rated private universities, the annual hit can be $60,000 and up — counting room and board, transportation, and incidentals. For out-of-state students, the annual cost to attend some public schools can be over $45,000. Yikes! Fortunately, a surprisingly high percentage of students at many schools receive at least some financial aid, and your child’s chances may be better than you think. So if your child cashes in, what are the tax implications? Here’s what you need to know.

The Basics

The economic characteristics of financial aid benefits determine how they are treated for federal income tax purposes.

Gift aid, which means free money that the student doesn’t have to work for, is often tax-free. Gift aid may be called a “scholarship,” a “fellowship,” a “grant,” or a “tuition discount.”

Arrangements where the student is required to work in exchange for money are also sometimes called “scholarships” or “fellowships,” but those are misnomers. Whatever payments for work may be called, they are considered compensation from employment and must be reported as income on the student’s federal income tax return.

Finally, the IRS doesn’t care whether financial aid comes from a government agency, a nonprofit, or a for-profit corporation. The federal income tax consequences of financial aid benefits only depend on their economic nature.

Most Gift Aid is Tax-Free

Free-money scholarships, fellowships, and grants are generally awarded based on either financial need (for example, federal Pell grants) or academic merit (for example, National Merit Scholarships). Such gift aid is nontaxable as long as:

  1. The recipient is a degree candidate, including a graduate degree candidate.
  2. The funds are designated for tuition and related expenses (including books and supplies) or they are unrestricted and are not specifically designated for some other purpose -- like room and board.
  3. The recipient can show that tuition and related expenses equaled or exceeded the financial aid benefits. To pass this test, the student simply must incur enough of those expenses within the time frame for which the aid is awarded.

If gift aid exceeds tuition and related expenses, the excess is taxable income to the student.

Ditto for Tuition Discounts

Gift aid that comes directly from the university is often called a “tuition discount,” a “tuition reduction,” or a “university grant.” These free-money awards fall under the same tax rules that apply to free-money scholarships, fellowships, and grants.

Example: Your college-bound daughter hits the financial aid jackpot and receives a completely free ride for her first year of school which begins in August of 2015 and ends in May of 2016. She collects scholarships, grants, and tuition discounts totaling $55,000 for the academic year (the first semester of which is in 2015 and the second semester of which is in 2016). Your kid’s tuition, mandatory fees, and books for the academic year will total $45,000. The remaining $10,000 is intended to cover room and board, optional fees, and incidentals. The $10,000 is taxable income and must be reported on your child’s tax returns. Since half of the $10,000 pertains to the first semester in 2015, she should report $5,000 on her 2015 return. The remaining $5,000 is for the second semester in 2016 and should be reported on her 2016 return.

Payments for Work Are Taxable

Under college work-study programs, students are given jobs to help finance their expenses. Work-study earnings count as taxable wages for federal income tax purposes. As explained later, however, this doesn’t necessarily mean the student will actually owe any tax.

Sometimes financial aid that is described as a “scholarship,” “fellowship,” “grant,” or “tuition reduction” is actually contingent on the student providing services to the school (teaching, research, etc.). Such payments are taxable compensation.

It is not the student’s problem to figure out how much is taxable in these situations. The financial aid payer should determine the taxable amount and report it to the student on Form W-2 (if the student is treated as an employee) or Form 1099-MISC (if the student is treated as an independent contractor).

Taxable Income Doesn’t Necessarily Trigger Taxes

Receiving taxable financial aid doesn’t necessarily mean owing anything to the IRS. Here’s why. A student who is not a dependent can offset taxable income with his personal exemption — $4,000 for 2015 — and his standard deduction — $6,300 for 2015 (assuming the student is unmarried). So a non-dependent student would not owe any federal income tax for 2015 if his income from taxable sources was $10,300 or less ($4,000 + $6,300 = $10,300).

If your child is still your dependent, she is not entitled to a personal exemption deduction (you claim it on your return). But the child’s standard deduction will still shelter up to $6,300 of 2015 earned income from federal income tax.

Taxable financial aid in excess of what can be offset by the student’s personal exemption (if any) and standard deduction will probably be taxed at only 10%. For 2015, an unmarried non-dependent student can have taxable gross income of up to $19,525 and still be in the 10% bracket. Any additional income will probably be taxed at only 15%.

Finally, if you don’t claim your child as a dependent on your federal income tax return, he or she can probably reduce or eliminate any federal income tax bill by claiming the American Opportunity tax credit (worth up to $2,500 for the first four years of undergraduate study) or the Lifetime Learning tax credit (worth up to $2,000 a year for years when the American Opportunity credit is unavailable).

Source: MarketWatch