How to Coordinate with Scholarships and Grants to Increase Your Education Credit and Reduce Your Tax Liability

One of tax saving tips for claiming education credit is to coordinate scholarships and grants. Generally, the scholarships or grants you receive are treated tax-free if you use them to pay qualified education expenses. However, if you can apply part or all of the scholarships and grants to non-qualified expenses and  include them in your gross income, you may be able to  claim more education credit and reduce your tax liability or increase your tax refund.  Whether you can benefit from using this tax saving method will not only depend on the amount and term of your scholarship or grant but also your federal and state tax rate and your eligibility for claiming other credit (such as earned income tax credit and child credit). Here is how you can determine if you should allocate any scholarship or grant to income to reduce your tax liability or increase your tax refund.

Step 1: Determine if you can allocate your scholarship or grant to gross income.

Check the terms of your scholarship or grant to see if they can be used for both qualified education expenses ( tuition and related fees) and non-qualified education expenses (rooms and board, etc.). You can allocate the scholarship or grant to gross income only if you can use them for both qualified and non-qualified education expenses.

Note: Even you use the scholarship or grant to pay tuition, you still can allocate them to non-qualified expenses and include the allocated part in income for tax purpose.

Go to Step 2-1 if you can claim American Opportunity Credit.

Go to Step 2-2 if you can claim Lifetime Learning Credit.

Step 2-1: Determine the amount of scholarship or grant you should include in gross income - American Opportunity Credit.

1. Use the example below as a reference to figure the amount of scholarship or grant you may want to include in gross income.

2. Prepare your federal income tax return without allocating any scholarship or grant to gross income.

3. Check the taxable income  on line 43 of Form 1040 and determine the amount of scholarship or grant you should allocate to gross income based on the guideline below.

This guideline is based on the fact that the  amount of American opportunity credit is the sum of 100% of first $2,000 plus 25% of next $2,000 qualified education expenses paid and federal income tax rates from 2016 federal tax rate brackets.

If you are qualified for earned income tax credit with one or more qualified child, you should allocate no more than $2,000 scholarship or grant to income when your income is within the phase-out income range for earned income tax credit.

Step 2-2: Determine the amount of scholarship or grant you should include in gross income -  Lifetime Learning Credit.

1. Use the example below as a reference to figure the amount of scholarship or grant you may want to include in gross income.

2. Prepare your federal income tax return without allocating any scholarship or grant to gross income.

3. Check the taxable income  on line 43 of Form 1040 and determine the amount of scholarship or grant you should allocate to gross income based on the guideline below.

This guideline is based on the fact that the amount of lifetime learning credit is 20% of first $10,000 qualified education expenses paid and federal income tax rates from 2016 federal tax rate brackets.

If you are qualified for earned income credit with one or more qualified child, do not allocate any scholarship or grant to income.

Step 3: Report the scholarship or grant income and take the education credit.

Report the amount of scholarship or grant you want to include in gross income on line 7 of Form 1040 and use Form 8863 to claim American opportunity credit or lifetime learning credit.

Note: For parents who claim education credit for your children on your return, if you decide to apply part of your children's scholarship or grant to non-qualified education expenses, you will include this part as your children's gross earned income on their return. They may need to file a return if their total income is over the filing requirement.

Example 1: Jack is a college student. In 2016, he paid $10,000 tuition and $7,000 room and board. He also received $10,000 scholarship and earned $10,000 wage from his summer job. The scholarship can be used for either tuition or room and board. Jack can be claimed as a dependent on his parent's return.

Case 1: Since the amount of scholarship is equal to the tuition he paid, if Jack does not allocate any of the scholarship to income, he has no qualified education expenses to claim American opportunity credit or lifetime learning credit. His tax liability will be $373.

Case 2: If Jack is qualified to claim American opportunity credit, he can allocate $414 to income to reduce his tax liability to $0. 

Case 3: If Jack is qualified to claim lifetime learning credit, he can allocate $3,730 to income to reduce his tax liability to $0.

  

For more details and examples of coordination with scholarships and grants, please see IRS publication 970 and instruction for Form 8863.


Related Article(s)
Example - How to Claim Maximum Education Credits (American Opportunity Credit or Lifetime Learning Credit)

Example–How to Determine Whether You Can Claim American Opportunity Credit or Lifetime Learning Credit

How to Use Form 1098-T to Figure American Opportunity Credit or Lifetime Learning Credit 

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