Fortunately, a surprisingly high percentage of students at many schools receive at least some financial aid, and your child's chances may be better than you think. So if your child cashes in, what are the tax implications?
If you are parent whose children have not yet started college, you may be shocked when the college-search begins, and the associated costs become clear. Costs to attend some colleges are approaching astronomical levels. Thankfully, there is a good amount of information out there if you know how to find it.
But for those already in the thick of it – with children attending college now -- here is some advice from a recent Smart Money article about financial aid and taxes; just how do taxes play out on financial aid money?
First, it depends on the nature of the aid: is it gift aid or is it offered as the payment for work?
Gift aid is essentially that money which the student doesn’t need to work for, including “scholarships,” “fellowships,” “grants,” “tuition discounts,” or “tuition reductions.” This money is not taxed so long as the recipient is eligible for a degree (including graduate degrees), the money is demonstrably going toward expenses (if it comes in the form of funds), and the associated costs are demonstrably higher than the received aid (and the recipient incurs those costs in the same time-period.) Any leftover gift aid, however, is taxable.
If the aid comes in the form of payment for work, as in the federal work-study program or in teaching assistance for the university, then the aid is also taxable, at least in principle. Receiving taxable financial aid doesn't necessarily mean owing anything to the IRS. Here's why: A student who is not a dependent can offset taxable income with his personal exemption – $3,650 for 2010; $3,700 for 2011 – and his standard deduction – $5,700 for 2010; $5,800 for 2011 (assuming the student is unmarried). So a non-dependent student would not owe any federal income tax if his income from taxable sources was $9,350 or less for 2010 or $9,500 or less for 2011.
If your child is still your dependent, he is not entitled to a personal exemption deduction (you claim it on your return). But his or her standard deduction will still shelter up to $5,700 of earned income in 2010 (or up to $5,800 in 2011).
Finally, if you don't claim your child a dependent on your return, he or she can probably reduce or eliminate any federal income tax bill by claiming the American Opportunity tax credit (worth up to $2,500) or the Lifetime Learning tax credit (worth up to $2,000).