Scholarships can be taxing

by John Pearson

Personal Finance: Student Financial Aid

May 2006

The interplay of financial planning and college planning can be so complex. That explains the "urban legends" that circulate among those of us in the trade. Here's one with some twists and turns - and a pitfall or two that should be avoided.

An attorney fully expected his son to be offered a full ride football scholarship at a major Midwestern university he dearly wanted his son to attend. For whatever reason, the scholarship was not forthcoming. Neither father nor son was happy.

We're told that dad, a tax attorney by trade, became aware that the university told its scholarship recipients that scholarships were totally tax-free. As a practitioner, he knew that is inaccurate. Only the portion used to pay tuition and required fees, books and supplies is tax-free. The remainder, if any, is usually considered taxable wages by the IRS.

Resolved to have the last word, he reported every member of the school's football team to the IRS for underreporting of income! He then used the IRS "tax-cheat finder's fee" as his own form of federal financial aid.

Now, having set the stage with that peculiar tale, let's look at a case where treating some of a student's scholarship as taxable income can actually produce - or at least preserve - a tax savings.

I met a family recently whose daughter received a full scholarship specified for tuition and fees by her chosen college. Due to their relatively low income, this family would expect to qualify for the $1,500 HOPE tax credit on the parents' 1040. However, since the university earmarked the scholarship for tuition and fees, the portion that the family would pay was, by default, for room and board. Room and board expenses do not qualify for the Hope Credit! If the scholarship award were not so specifically earmarked, the taxpayer could determine what money is used for what college expense.

So how might this family have saved taxes?

If the university had not tagged the scholarship dollars for tuition and fees, the daughter could have elected to apply, say, $5,000 toward room and board -- taxable income to herself. On her tax return, the income would be fully sheltered by her own standard deduction, so daughter's income tax on the $5,000 would be zero.

Mom and dad could still claim daughter as an exemption. The tuition and fees scholarship dollars are not considered 'support.' Mom and dad provided the majority of her other needs, including the remaining tuition and fees. The Hope credit would have been there for the taking. Opportunity missed.

John Pearson is a CPA and certified college planning specialist. He can be reached at john@johnpearsoncpa.com.