In today’s day and age a large majority of the future workforce will at one time or another attend college. Whether it ends up being the foundation for their future job or simply a stepping stone to finding out what they really want to do. Unfortunately, as we have seen, that schooling is far from cheap. Most students attending college are taking on debt to cover the costs or, if lucky enough, finding scholarships to help defray some of the ever increasing costs.
Thanks to our tax code, most taxpayers are afforded some small deductions for those costs in the way of tuition deduction credit ($2,500 annual maximum credit) and student loan interest deduction ($2,500 annual maximum deduction). For most people, that is where the focus stops, but not for the Internal Revenue Service.
The receipt of scholarship funds could be taxable; and even worse yet they could be taxable at the parents’ tax rate! Currently the IRS Code allows for scholarships which are for “tuition and fees required for attendance and other expenses required for courses” to be excluded from income tax. However, scholarships and grants that also help to defray other costs (such as room and board or non-required expenses) are subject to tax. To add insult to injury, the IRS code currently does not treat scholarships as earned income which means they would fall under the “kiddie tax” rules and end up being taxed at the parents (usually) higher tax rate. For some that could mean that the scholarship they receive for $2,000 toward room and board will cost them nearly $800 in Federal Income Taxes!
Scholarships aren’t the only trap that lays waiting in the area of tuition. Student loans that provide a means to afford college currently often can have consequences that were overlooked down the road. As stated above, student loan interest is deductible from income (up to $2,500 per year); however, with any good tax deductions comes an “except”. As students graduate and being working (and earning assumedly higher incomes) the student loan interest deduction may be lost as it is phased out for higher income earners which are often those with larger student loans. Also, since it is first limited to $2,500 per year it may make sense to pay down some of that debt during schooling. Moving debt from a student loan to another loan that is tax deductible after graduation may make tax sense but be careful as that may create other risks and liabilities you don’t have with a student loan.
Other concerns with student loans do not relate at all to taxes but still should be on everyone’s radar. Private Student Loans (PSL) can have lower interest rates than Federal Student Loans (FSL), but they also often have more restrictions. Should the signer or co-signer on a PSL die during the loan, most loans become automatically due! Unsubsidized student loans accrue interest during while in school so that cost continues to pile up, whereas subsidized student loans do not accrue interest until graduation. Finally, even debt forgiveness comes with tax problems. If you are able to get that loan written-off or “forgiven” (either by the lender or even through some student loan forgiveness programs) that does not mean all is forgiven. The amount of debt forgiven is added to your taxable income so you are taxed on the debt as though you earned the money and paid it off.
Sending your children to college is often a great plan for their future, but be aware of the tax and financial consequences that come along with any long-term decision. Our staff is here to help you navigate the tax aspects of all your decisions; big or small. Let Reilly, Penner & Benton help, so don’t hesitate to call.