Q. What is the deal since I am already getting taxed on that money in my taxes?
A. Do not report her scholarship income on your tax return. It goes on her tax return only. The "kiddie tax" (form 8615) does apply. So, she is being taxed at YOUR marginal tax rate, not her own. Entering your information is just to determine the tax rate. It does not add any of your income to her tax return.
Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $14,600 filing requirement (2024) and the dependent standard deduction calculation (earned income + $450). It is not earned income for the kiddie tax and other purposes (e.g. EIC). For grad students and post grad fellows, scholarship, stipend and fellowship income is earned income ("compensation") for IRA contributions.
There is a tax “loop hole” available to claim an education credit, for the parents of students on scholarship. The student reports all his scholarship, up to the amount needed to claim the American Opportunity Credit (AOC), as income on his return. That way, the parents (or himself, if he is not a dependent) can claim the tuition credit on their return. They can do this because that much tuition was no longer paid by "tax free" scholarship. You cannot do this if the conditions of the grant are that it be used to pay for qualified expenses.
Using an example: Student has $31239 in box 5 of the 1098-T and $9654 in box 1. At first glance he/she has $21585 of taxable income and nobody can claim the American opportunity credit. But if she reports $25585 as income on her return, the parents can claim $4000 of qualified expenses on their return.
Books and computers are also qualifying expenses for the AOC. So, extending the example, the student had another $1000 in expenses for those course materials, paid out of pocket. She would only need to report $24585 of taxable scholarship income, instead of $25585.
The IRS actually encourages use of this technique. From the form 1040 instructions: “You may be able to increase an education credit if the student chooses to include all or part of a Pell grant or certain other scholarships or fellowships in income. For more information, see Pub. 970, the instructions for Form 1040 and IRS.gov/EdCredit". PUB 970 even has examples of how to do the “loop hole”.
Taxable scholarship goes on line 8r of Schedule 1, from which TT treats it as hybrid income.
