2018 Tax Strategy for College Scholarship Money

[Greenfroggies]

I am trying to take advantage of all available tax credits as well as reduce the tax burden on my son's scholarship money, while at the same time be compliant with the 2018 tax laws.  

 Background: 

My son receives scholarship funds from multiple sources, and he receives more in scholarship funds than he pays in college expenses.  None of the scholarships are restrictive as far as I am aware.  The university applies funds to the charges due first in the order that they are received.  Once all scholarships are applied to outstanding charges, excess scholarship funds are refunded to the student.  In addition to the scholarship money, I am the owner of a 529 account (my son is the beneficiary)  from which I would like to withdraw whatever funds I can without incurring penalties or taxes.  

 Proposed Strategy:

1) Take a portion of the AOTC (between $2K and $2.5K) on my husband's and my tax return, based on the eligible amount paid for tuition, fees and required books and materials.   Based on our income, we will be eligible for AOTC.

2) Withdraw 529 funds for the equivalent amount of the dining and residence fees paid to the university plus eligible items like computer/printer, and supplies not already included for the AOTC (I am not suggesting double dipping) prior to the end of 2018.  I would have the proceeds go to my son, the beneficiary of the account, not to myself.  

3) Declare all scholarship funds as taxable on my son's tax return, not my husband's and my tax return.  My son will check that he is declared a dependent on our tax return.  

4) Since scholarship money is considered earned income up to the amount of the standard deduction, he should be allowed $12K in deductions for scholarship money in 2018.  He will not have any actual earned income. Since the scholarship amount in excess of the standard deduction will be considered unearned income, he will have to pay taxes at the kiddie tax rate on any amount over $2,100, if I am not mistaken.  However, since the excess amount will be under the $2,100 threshold in 2018, he should owe $0 in taxes.  

Using this strategy, we would be able to take advantage of the AOTC, be able to withdraw some funds from his 529 tax free and not pay taxes on the scholarship funds.  

I arrived at this strategy by reading a lot of articles and forums on the web.  However, there was no one single article which dealt with my situation exactly.  I am not sure if I am correct, and I would very much appreciate it if those more knowledgeable than me could review my strategy and offer feedback.  

[Carl]

1) I don't see how you'll qualify for any AOTC since scholarships received in 2018 will exceed qualified expenses paid in 2018. Scholarship funds refunded to the student, are taxable income *TO THE STUDENT*. Period.  Now there is a way to "work it" so that the parents qualify for and can take the AOTC. But I don't see how since scholarships more than cover the expenses they are qualified to be used for. It also doesn't change the fact the scholarship funds paid/refunded to the student are taxable income to the student.

2) If you are the named beneficiary on the 529, the proceeds are reported as paid to you and you report those proceeds on your tax return. If you are claiming the student as your dependent, and you use those funds to pay qualified expenses with, then they are tax exempt and will NOT qualify anyone for the AOTC. If the student is the named beneficiary then the funds go to the student and the student will report on the student's tax return the receipt, as well as the disposition of those funds to pay for qualified education expenses. Again, those funds will not qualify anyone for the AOTC.

3) I'm sure you're aware of this, but I'll say it anyway for clarity. Your son has no choice but to claim excess scholarship funds on his return.

4) No. Scholarship, grant and 529 monies are "NOT" considered earned income. The student didn't go out and "do something" on a recurring basis to earn it. It's considered 3rd party support, and any excess not used for qualified expenses is taxable income to the student. (For the 1099-Q, if the parents are the named beneficiary, then any excess not used for qualified expenses is taxable income to the parents.)

None of the scholarships are restrictive as far as I am aware.

To clarify that statement, unless otherwise stated by the giver of the scholarship or grant, those funds can only be used for tuition, books, and lab fees. While the category of "lab fees" is rather broad and includes computers required for college, there are no exceptions to that.

Whereas 529 funds can be used for tuition, books and lab fees, they can also be used for the unqualified education expenses of room and board, *provided* that room and board was in direct support of the education. So if the student is not enrolled for any summer courses, room and board for those months is not allowed to be included as a 529 expense.

Where most miss out on this is that they forget that the "room" part includes more than just the rent. It also includes the cost of utilities, to include Internet access if required for the education. On the "board" part most forget that entirely and it doesn't click with them that "board" refers to the cost of food.

[Greenfroggies]

I do appreciate your reply; however, your responses are not aligned with the articles I have read, and I have spent hours combing the web for information related to my particular situation.  

[Greenfroggies]

Carl,  

I did my best to look up the tax code to provide additional clarity on my original post.  Per IRS Publication 901, Earned income includes salaries, wages, professional fees, and other amounts received as pay for work you actually perform. Earned income (only for purposes of filing requirements and the standard deduction) also includes any part of a taxable scholarship. See chapter 1 of Pub. 970, for more information on taxable and nontaxable scholarships. 

So, while scholarships are not technically "earned", the IRS considers them earned, solely for the purpose of the standard deduction.  The amount exceeding the standard deduction would be considered unearned.  

Parents may choose to consider scholarship funds as tax free for tuition and eligible expenses OR they may choose to designate the scholarship funds as taxable in order to qualify for the AOTC. This is outlined in IRS Pub 970, Chapter 2.  The tax publications also state that the parents take the AOTC even though the student files the return with the scholarship as taxable income if the student is a dependent.  I used the term "restrictive" to mean how a scholarship is used.  I realized, after reading your response, that you interpreted "restrictive" differently than I had intended. There are instances when an institution providing the scholarship "restricts" how the scholarship may be used.  In other words a scholarship restricted to tuition may only be used for tuition, and if there is any excess, it must be returned.  

[Carl]

Be aware that the student will pay "kiddie tax" on unused scholarship/529 funds, meaning that the excess will be taxed to ths student, at the parent's higher tax rate. This only applies to excess scholarship/529 funds, and not other income the student may receive. So from the "family" viewpoint, what you get for AOTC, the student will pay a higher tax rate on. In some cases, (which is not common) the higher tax the student pays, is darn close to the same amount the parent's get for AOTC. Though I've never heard of it going over.

[Greenfroggies]

Carl, Yes, that is the situation I am trying to minimize.  From what I have read, for 2018, it is not the parents' rate, but rather the rate used for "trusts" which can be quite high.  This change, as I understand it, is part of the 2018 tax reform.  I think, but I'm not certain, that it applies to the amount of unearned income above $2,100.   And yes, one would need to be careful not to negate the benefit of the AOTC.  

[Carl]

Overall, interpretation of the regs for 2018 are not easy, or very clear really. There's to much "wiggle room" for interpretation on a lot of them still. The ones for education didn't change that much. But what did change, seems to wiggle a lot. 🙂 About the only thing that is clear, is the phase out of the education credits based on MAGI.