Financial Aid and Your Taxes
Applying for, and paying back, financial aid to ease the burden of your academic journey can be challenging enough, but what happens when you factor taxes into the equation? There is a complex relationship between student financial aid and taxes that not a lot of people understand, and it’s one that can cause various pitfalls as you pay for college and pay your taxes. We have put together an overview of what you need to know when it comes to financial aid and your taxes.
What Is Financial Aid?
Let’s look at a basic question: What is financial aid? In the simplest of terms, financial aid is money that is given to a college student to help them afford the expenses related to their education, including but not limited to:
- Room and board
- Supplies and living expenses
Financial aid comes in many forms: grants, scholarships, loans, work-study programs, or a combination thereof. Grants and scholarships are awards, and as such, they do not need to be paid back. A loan is a sum of money that the student and/or their family borrow from a bank or a financial services company, and has to be paid back – usually over a long period of time, and with an interest payment on top of the principal (the original amount of the loan). A work-study program allows a student to earn money, or credit to their tuition bill, for an on-campus job.
One of the most critical components of financial aid for college and university is the Free Application for Federal Student Aid, or FAFSA. The U.S. Department of Education uses the FAFSA to determine the Expected Family Contribution (EFC), or how much of the college tuition your family can reasonably afford. Once this figure is determined, the Education Department or other student loan providers will take the EFC into consideration when loaning you money. Almost every federal and state grant in the United States requires a FAFSA when deciding how much financial aid to allocate to a student (in fact, an offer of financial aid that claims to not require the FAFSA should be regarded with suspicion as a potential scam).
How Do Tax Returns Affect the FAFSA?
Business Insider reports that the sheer weight of information required by the FAFSA – 153 questions crammed into six pages – leads many students and their families to make mistakes while calculating their taxes and financial aid applications.
For example, lots of families make the mistake of filing their taxes before moving onto the FAFSA. Ostensibly, this is a good idea, but putting off the FAFSA is, in the words of Business Insider, “a big no-no,” primarily because the FAFSA can be updated online – with your latest tax return information – once it has been filed. Indeed, Fastweb strongly recommends that the FAFSA be filed “as soon as possible,” using estimated numbers to complete the form.
As an alternative to manually updating your FAFSA with correct tax information, FAFSA’s IRS Data Retrieval System will automatically transfer your tax information to your FAFSA.
Other FAFSA and tax errors include reporting the total income tax as equal to the Adjusted Gross Income (the Adjusted Gross Income should typically be lower than total income tax), misidentifying the head of the household, and erroneously indicating that a federal tax return was not required to be filed, even though the stated household income was above the IRS filing threshold.
Some kinds of financial aid (like grants and scholarships that go towards living and other expenses of being in college) may be considered as “taxable income” by the IRS and must be declared on tax returns. Federal Pell Grants, for example, which are limited to students who demonstrate financial need and have not yet earned their first bachelor’s degree (and who are in a program that will culminate in a degree), are not considered taxable income by the IRS – unless it is found that the recipient student has used the money from the grant for unauthorized purposes, such as paying room and board or travel expenses instead of the intended target of the loans:
The IRS calls these “qualified educational expenses.” If the IRS or Department of Education finds that the student has misappropriated the Pell Grant in this way, then the student is required to declare these expenses on their tax returns.
A student loan is not considered to be taxable income because you, as the recipient of the loan, have to pay it back (with interest). If, however, any amount of the loan is forgiven, that amount would become taxable income for that year.
Tax Deductions and Credits
The IRS also offers specific tax deductions and credits to qualifying students and their families.
Tax deductions reduce taxable income, which reduces tax liability. A tax deduction is not a reduction of the amount of tax owed, which is closer to what a tax credit is. A tax credit, on the other hand, refers to any amount of money that you as a taxpayer can subtract from the amount of tax you owe to the government. While a tax deduction reduces the amount of your income that is taxable, tax credits reduce the amount of the tax itself.
For example, the American Opportunity Tax Credit gives students and their families a 100 percent tax credit for the first $2,000 they spend on colleges, and 25 percent on the next $2,000. This makes for a total credit for $2,500 per student, but only for the first four years of college, provided that they maintain at least part-time student status. Furthermore, the credit will phase out for taxpayers making more than $80,000 a year on their own, or $160,000 a year for married couples.
Another popular tax credit for students is the Lifetime Learning Credit, which can be claimed by the student, the student’s spouse, or the student’s parent. It can be claimed for a deduction of up to $2,000 per household, but not by the same student if he or she has claimed a different tax credit within the past year of their claiming the Lifetime Learning Credit. Also, if the taxpayer’s income exceeds $47,000, the credit is phased out.
On the deduction side, there is the Student Loan Interest Tax Deduction, where any interest paid on a student loan is eligible for deductions (maximum amount $2,500) if the loan was taken out exclusively to meet education expenses. The student has to be the taxpayer, their spouse or their dependent, and has to be enrolled at least part-time in a degree-seeking program.
Understanding Financial Aid and Your Taxes
The idea of combining the hassle of filing your taxes with the hassle of applying for financial aid seems almost insurmountable, leaving many students and their families to miss out on aid awards, loans, deductions, and credits that they otherwise would have received. That’s why we are here for you. We can make this mess of rules, restrictions, and regulations accessible and comprehensible, and help you understand where your taxes fit into the grand scheme of financial aid for you, your spouse, or your children. Please take some time to read the articles and blogs on our website to learn more on the topic of financial aid and your taxes. But also consult with a tax advisor for the most up-to-date information about financial aid and taxes.