So, your child received a college scholarship. Congratulations! But before you start adjusting your college budgets, you need to consider any taxes due on the scholarship.
If a scholarship is used to pay for college tuition, fees, books, or required equipment, it’s not taxable. But if the scholarship is used to cover room and board, travel costs, or optional equipment, or if it’s awarded as payment for teaching, research, or some other required service, then it is taxable.
With most scholarships, the recipient can decide how to apply the money. Your first instinct may be to have your child apply it to tuition, fees, or books (making it tax free). But be aware that this may impact your ability to claim the Lifetime Learning or the American Opportunity (formerly the Hope) tax credits. That’s because these credits are based on the amount of tuition and fees you pay, and any tuition and fees paid with a tax-free scholarship can’t be counted when calculating your credit.
This rule has the most impact on your ability to claim the Lifetime Learning credit, worth up to $2,000. Why? This credit is calculated as 20% of the first $10,000 of tuition and fees, so a hefty scholarship applied to these expenses may leave you with less than $10,000 in eligible tuition and fees to count toward the credit. The American Opportunity credit, worth up to $2,500, is calculated differently–100% of the first $2,000 of tuition and fees, plus 25% of the next $2,000 of such expenses. (You can only take one of these credits in a given year for the same student.)
If the scholarship has no restrictions on how it can be applied (and assuming you meet the income limits to take the credits–each credit has different income limits), consider running some numbers to determine your best option: (1) apply the scholarship to tuition and enjoy its tax-free status, but reduce the amount of eligible tuition that can be used to calculate the tax credits, or (2) apply the scholarship to room and board and pay income tax on the scholarship, but allow all tuition to be counted when calculating the credits. When running the numbers, keep in mind that generally a tax credit is more valuable than a tax deduction because it reduces your taxes dollar for dollar.
For more information, see IRS Publication 970, Tax Benefits for Education.