First of all, congratulations on graduating high school and getting into college! College opens a whole new world for a student's growth and learning, along with a myriad of tax considerations.
One of the first concerns that comes up in a college discussion is the cost. Many taxpayers will rely on government and private loans to pay the bill, but some students will qualify for scholarships, fellowships, and tuition discounts. Here are some guidelines under these circumstances:
Taxable scholarships, fellowships, & tuition assistance
- Total received by a student who is not a degree candidate
- Any amount that was a payment for services performed
- Any amount used for room, board or other expenses that do not qualify as tuition, fees, and course requirements
- Other non-taxable income for school expenses that is used for nonqualified expenses such as room, board and travel.
In most cases, any amount that is considered taxable should be added to page one of the tax return as other income.
In most cases, school loans are not considered taxable income and do not have to be reported on a tax return.
For those that rely on loans to pay for college, the interest component on the repayment is deductible on page 1 up to $2,500 per year subject to AGI thresholds.
Qualified Tuition Programs
Some students can take advantage of a qualified tuition plan commonly called a "529 Plan" to pay for college. Qualified tuition plans are set up for the benefit of the student to pay education expenses. The benefit of these plans are the tax-free earnings of the account if the student uses the funds for qualified education expenses. In most cases, family members have been contributing to the plan for years before the student is expected to need the funds. Distributions from this plan are tax-free when used for qualified expenses. However if a student takes a greater withdrawal from the plan than qualified expenses, part of the earnings may be taxable to the student. The earnings portion that is not used for qualified expenses will also be subject to a 10% penalty unless an exception applies. When calculating the portion of the earnings that may be taxable you cannot include the expenses used to calculate education credits. If a portion of the earnings from a qualified tuition plan is taxable because of a reduction of education expenses due to scholarships or used in the calculation of an education credit the 10% penalty does not apply.
Education Savings Plans
Education savings plans also known as "Coverdell ESPs" are another option for paying for college. ESPs are similar to Qualified Tuition Plans. They also have tax free earnings if the distribution is used for qualified expenses however ESPs are not limited to higher education expenses but can also be used for elementary and secondary expenses as well. They are subject to the same 10% penalty and rules for determining the taxability of earnings as Qualified Tuition Plans. If a student has both a Qualified Tuition Plan and an Education Savings Plan, any distributions in excess of qualified expenses must be split between the two plans to determine taxability of earnings.
The big difference in QTPs and ESPs is in the requirements and limitations for contributions. If families are interested in making contributions for the benefit of a student please contact your tax advisor to determine which would be beneficial for your specific situation.
IRA's & Roth IRA's
If a student or the student's parents want to take a distribution from an IRA or Roth IRA to pay for school expenses they may do so and avoid any early withdrawal penalties if they are under age 59 ½. The money still follows the taxability rules based on the type of account for the person taking the distribution, but the distribution will not be subject to the 10% penalty. So be aware that although you won't incur a penalty, you could be changing your tax situation by increasing your taxable income and additional income tax may be due.
Now that you have figured out how to pay for college do you want to know what's deductible? See the second part of our College Bound Series: Tuition, Fees, & Course Requirements.