1 Fact Sheet: Interaction of Pell Grants and Tax Credits: Students May Be Foregoing Tax Benefits by Mistake For students with scholarships, such as Pell Grants, the process for claiming education-related tax credits, like the American Opportunity Tax Credit (AOTC), is unusually complex and results in many eligible students and parents (if the student is a dependent) foregoing tax credits for which they qualify. The magnitude of the problem appears to be large the complexity affects at least the almost 9 million students who receive Pell Grants and results in hundreds of millions of dollars of unclaimed credits each year. Under current law, a student may choose whether to allocate his Pell Grant (and many other scholarships) to tuition, fees, and course related materials or to living expenses when filing a tax return. This choice is important because if the student allocates his Pell Grant or other scholarships to tuition and fees, the scholarship reduces the amount of expenses eligible to be used to claim education-related tax credits. If allocated to living expenses, however, then the scholarship becomes taxable for the student. (Students have this choice regardless of how the school applies the scholarship.) Maximizing the total value of scholarships and tax benefits can therefore require complicated calculations of the value of the credit (to the student or to the parent, if applicable) relative to the tax liability resulting from counting the scholarship as income. Students may not understand that they have this option, and many would benefit from better guidance in their decision making. While eliminating this source of complexity would require legislation, the dissemination of accurate and clear information to students, taxpayers, colleges and universities, tax preparers, tax software providers, and other stakeholders can help students and their families to receive the education tax benefits for which they are eligible. Current Law: The AOTC is a tax credit generally available to students in the first four years of postsecondary education to offset costs for qualified tuition and related expenses (QTRE), which includes tuition, required fees, and course materials. The AOTC provides a 100 percent credit for the first $2,000 of QTRE and a 25 percent credit for the next $2,000, for a total credit of up to $2,500. Forty percent of the otherwise allowable AOTC, up to $1,000, is refundable. In addition, students who are not eligible for the AOTC may be eligible for a Lifetime Learning Credit (LLC) in any year of postsecondary study. The non-refundable LLC is equal to 20 percent
2 2 of up to $10,000 of qualifying expenses per tax return. Pell Grants (and many other scholarships) can be treated in one of two ways for tax purposes: 1. Tax-free and subtracted from AOTC-eligible expenses. Pell Grants allocated to QTRE are excluded from taxable income, but they are also subtracted from QTRE for purposes of the AOTC and LLC, potentially reducing the credit for which students are eligible. 2. Taxable and not subtracted from AOTC-eligible expenses. Pell Grants allocated to living expenses such as room and board are included in the student s taxable income and are not subtracted from QTRE for purposes of the AOTC and LLC, potentially increasing the credit for which students are eligible. Current law generally allows students to decide whether to treat their Pell Grants as paying for QTRE or for living expenses. Notably, a student may choose to treat her Pell Grant as paying for living expenses even if the institution applies the Pell Grant against tuition and fees. A student may allocate Pell Grant funds toward living expenses up to the amount of her actual living expenses, which may differ from the living expenses estimated by her school in computing her official cost of attendance under student aid rules. The federal tax requirements applicable to this allocation decision are that 1) any scholarship (including a Pell Grant) be used in a manner consistent with its terms, 2) any scholarship that is allocated to QTRE be subtracted from QTRE for purposes of the AOTC (or LLC), and 3) any scholarship that is allocated to living expenses be included in taxable income on the student s (and not the parent s) federal income tax return. The Issue: Many students would benefit by claiming at least a portion of their QTRE for the AOTC, even if that requires including some of their Pell Grant (or other scholarships) in taxable income (see examples below). If a student s QTRE exceeds his scholarships by $4,000 or more, the student can claim the maximum AOTC without having to include any scholarship in income. But if QTRE minus scholarships is less than $4,000, the student may benefit by including a portion of the scholarship in income in order to claim a larger AOTC. Most Pell Grant recipients who are eligible for the AOTC would benefit from allocating a portion their Pell Grant to living expenses so as to be able to claim at least $2,000 of QTRE for the AOTC. However, the tax-minimizing allocation of Pell Grants and other scholarships between QTRE and living expenses depends on a number of factors, including the terms of each scholarship, the amount of scholarships and expenses, the student s marginal tax rate and income tax available for use against the non-refundable share of AOTC or LLC, and, in the case of tax dependents, the parents income tax before AOTC or LLC. The calculation of the optimal strategy is especially complicated because in the case of a dependent student it may depend on two tax returns and because a student s marginal tax rate may change depending on how much of the scholarship is included in income. The optimal strategy is specific to each student s situation. Taxpayers may be unaware that they have a choice of how to allocate scholarship funds between QTRE and living expenses on their tax return. However, IRS regulations provide that the student may treat scholarship funds to have been used for non-qtre such as room and board, simply by
3 3 including the funds in income, as long as the scholarship is allowed to be used for non-qtre expenses, as is the case with Pell Grants. (See section 1.25A-5(c) of the regulations.) How You Can Help: You can inform students that they have a choice in how to allocate Pell Grants for tax purposes. Information available to guide taxpayers can currently be found on page 14 of Publication 970. In addition, the Tip Box on Form 8863 (used to claim credits) now explains that taxpayers may be able to reduce their tax liability if they include some of their scholarships in income. The IRS is also planning to provide Q s and A s on this topic on their webpage.
4 4 Example 1: Families that Misallocate their Expenses May Forego Tax Benefits 1 The family has earned income of $22,000 ($20,000 earned by the taxpayer, and $2,000 by a dependent student). The family has $4,000 of QTRE and receives the maximum Pell Grant of $5,645. The student has living expenses in excess of $5,645. For this family, total benefits are maximized if they allocate $4,000 of their Pell Grant to living expenses, so that they can claim the maximum AOTC. If the family paid the entire tuition with the Pell Grant, the family would not be eligible for any AOTC. If the family puts the entire Pell Grant toward living expenses, the family s tax refund is maximized, even though the total amount of tax before considering the AOTC is higher. Column 1: This family allocates the Pell Grant to the first $5,645 of the student s living expenses. This leaves $4,000 of tuition expenses available for an AOTC of $1,300. The student s tax liability is $145 after including the Pell Grant in income. Altogether, the family s total tax liability is reduced by $1,155 Column 2: This family allocates the Pell Grant to all $4,000 of tuition, leaving no expenses eligible for the AOTC, and thus, receives no education credit. While the student has $0 in tax liability, the family forfeits $1,155 in benefits. Scholarship Used to Pay Scholarship Used to Pay Living Expenses Tuition, Fees, and Books Total Pell Grants 5,645 5,645 Pell Used to Pay Tuition, Required Fees and Books 0 4,000 Pell Used to Pay Living Expenses 5,645 1,645 Expenses Eligible for AOTC (up to $4,000) 4,000 0 Total Income Parent 20,000 20,000 Taxable Income 3,000 3,000 Tax Before Credits AOTC 1,300 0 EITC 2,958 2,958 Tax Liability of Parent 1-3,958-2,658 Total Income Student 7,645 3,645 Taxable Income 1,445 0 Tax Liability of Student Total Tax Liability of Family -3,813-2,658 Net Loss from Failing to Optimize Benefits 2 1,155 1 Negative values indicate that the family is receiving a refund. 2 The net loss from failing to optimize benefits equals the value of the foregone AOTC minus the tax the student avoids by using the Pell for tuition and excluding it from income. 1 All calculations in Example 1 and Example 2 use parameters for Due to rounding rules, amounts presented here may differ slightly from amounts based on the tax tables the IRS will produce for the filing season.
5 5 Example 2: Maximizing Total Tax Benefits May Mean Foregoing Some AOTC This family consists of a parent who attends school full time while raising a dependent child eligible for the EITC. The parent has earned income of $20,000. She has $4,000 of QTRE and receives the maximum Pell Grant of $5,645. Her living expenses are in excess of $5,645. For this family, total benefits are maximized if the taxpayer allocates $2,000 of her Pell Grant to QTRE living expenses, so that she can claim $2,000 in expenses to qualify for the AOTC. If the family paid the entire tuition with the Pell Grant, the family would not be eligible for any AOTC. If the family put the entire Pell Grant toward living expenses, AOTC would be maximized, but tax after credits would increase. Column 1: The family applies the Pell Grant to pay the first $3,645 of the student s living expenses. This leaves $2,000 of tuition expenses available for an AOTC of $1,465 and an EITC of $2,376. Column 2: The family applies the Pell Grant to all $4,000 of tuition, leaving no expenses eligible for the AOTC. This family receives no AOTC and an EITC of $2,695. Relative to the optimum split, this family leaves $946 on the table. Scholarship Partially Used Scholarship Used to Pay to Pay Living Expenses Tuition, Fees, and Books Total Pell Grants 5,645 5,645 Pell Used to Pay Tuition, Required Fees and Books 2,000 4,000 Pell Used to Pay Living Expenses 3,645 1,645 Expenses Eligible for AOTC (up to $4,000) 2,000 0 Total Income Student/Taxpayer 23,645 21,645 Taxable Income 6,645 4,645 Tax Before Credits AOTC 1,465 0 EITC 2,376 2,695 Tax Liability of Student/Taxpayer 1-3,176-2,231 Net Loss from Failing to Optimize Benefits Negative values indicate that the family is receiving a refund. Tax liability includes the EITC, which varies with income. We have assumed the dependent does not qualify for the child credit because the child credit is not affected in this example. 2 The net loss from failing to optimize benefits equals the value of the foregone AOTC minus the tax the student avoids by using the Pell for tuition and excluding it from income minus the value of the increase in the EITC from excluding the Pell from income.
Table of Contents Introduction... 1 Life Expectancy for a 65-Year-Old Person...1 Questions to Ask Before Withdrawing Your Account...2 Tailoring Your Withdrawal Decisions to Your Personal Needs...3 Leaving
TEACHERS AND STATE EMPLOYEES RETIREMENT SYSTEM YOUR RETIREMENT BENEFITS Member Handbook Department of State Treasurer Raleigh, NC Revised January 2015 NORTH CAROLINA DEPARTMENT OF STATE TREASURER RETIREMENT
Building Your Future: Succeeding A Student and Teacher Resource for Financial Literacy Education Copyright 2013, 2014 The Actuarial Foundation About This Book Personal finance is part knowledge and part
Financial Aid Reform for the 21 st Century Student By Mark Huelsman and Alisa F. Cunningham January 2013 EXECUTIVE SUMMARY A s postsecondary education becomes increasingly vital to participate and succeed
When to Claim Social Security Retirement Benefits David Blanchett, CFA, CFP Head of Retirement Research Morningstar Investment Management January 10, 2013 Morningstar Investment Management Abstract Social
How Social Security Benefits Are Computed: In Brief Noah P. Meyerson Analyst in Income Security February 4, 2015 Congressional Research Service 7-5700 www.crs.gov R43542 Summary With about $900 billion
Protecting Your Health Insurance Coverage This booklet explains... Your rights and protections under recent Federal law How to help maintain existing coverage Where you can get more help For additional
The Health Care Assister s Guide to Tax Rules Determining Income & Households for Medicaid and Premium Tax Credits Center on Budget and Policy Priorities Authors January Angeles and Tara Straw Acknowledgements
Effect on Net Worth of 15- and 30-Year Mortgage Term John R. Aulerich 1, The choice between a 15-year and 30-year fixed-rate mortgage term is evaluated considering the borrower s income tax rate, ability
State of Wisconsin Department of Revenue Wisconsin Homestead Credit Situations and Solutions Publication 127 (02/15) Table of Contents I. INTRODUCTION... 3 II. SITUATIONS AND SOLUTIONS... 3 A. Situations
Using Credit to Your Advantage. Topic Overview. The Using Credit To Your Advantage topic will provide participants with all the basic information they need to understand credit what it is and how to make
Audit to Determine if Cohort Default Rates Provide Sufficient Information on Defaults in the Title IV Loan Programs FINAL AUDIT REPORT DECEMBER 2003 Our mission is to promote the efficiency, effectiveness,
2014 How America Pays for College Sallie Mae s National Study of College Students and Parents Conducted by Ipsos Public Affairs About Sallie Mae Sallie Mae (NASDAQ: SLM) is the nation s No. 1 financial
Variable Annuities What You Should Know Information is an investor s best tool WHAT YOU SHOULD KNOW 1 2 VARIABLE ANNUITIES Variable Annuities Variable annuities have become a part of the retirement and
A retirement PLANNING GUIDE USING YOUR HOUSE for INCOME IN RETIREMENT It s something Americans increasingly need to consider. And increasingly need to do. A retirement PLANNING GUIDE By Steven Sass, Alicia
An NCPR Working Paper What Is Known About the Impact of Financial Aid? Implications for Policy Bridget Terry Long Harvard Graduate School of Education, National Bureau of Economic Research, and National
NEW AMERICA EDUCATION POLICY JASON DELISLE AND BEN MILLER Myths & Misunderstandings The Undeserved Legacy of Year-Round Pell Grants @NEWAMERICAED REPORT JANUARY 2015 #YEARROUNDPELL EDCENTR.AL/YEARROUNDPELL
Using Behavioral Economics to Inform the Integration of Human Services and Health Programs under the Affordable Care Act Prepared by: Fredric Blavin, Stan Dorn, and Jay Dev The Urban Institute Under Task
After You Retire FRS PENSION PLAN 2011 EDITION Department of Management Services Division of Retirement DISCLAIMER T his brochure is written in nontechnical terms, avoiding the formal language of the retirement