Now that your loved one is off to school, it’s time to begin paying the tuition and other related expenses. We have a number of tax-advantaged strategies you can consider to help with the high cost of college.
Many students apply for a variety of scholarships – whether athletic, academic or needs-based – and most of these are exempt from income tax, if certain conditions are satisfied.
The most important condition is that the scholarship must not be compensation for services, and it must be used for tuition, fees, books, supplies, and similar items (and not for room and board). Although a scholarship is tax-free, it will reduce the amount of expenses that may be taken into account in computing the American Opportunity Tax Credit and Lifetime Learning credits, and may therefore reduce or eliminate those credits.
In an exception to the rule that a scholarship must not be compensation for services, a scholarship received under a health professions scholarship program may be tax-free even if the recipient is required to provide medical services as a condition for the award.
In addition to merit-based or needs-based scholarships, many students receive financial gifts from family members or other loved ones.
If someone other than you pays your child’s college expenses, the person making the payments is generally subject to the gift tax, to the extent the payments and other gifts to the child by that person exceed the regular annual (per donee) gift tax exclusion of $16,000 for 2022. Married donors who consent to split gifts may exclude gifts of up to $32,000 for 2022.
However, if the other person pays your child’s school tuition directly to an educational institution, there’s an unlimited exclusion from the gift tax for the payment. The relationship between the person paying the tuition and the person on whose behalf the payments are made is irrelevant, but the payer would typically be a grandparent.
The unlimited gift tax exclusion applies only to direct tuition costs. There’s no exclusion (beyond the normal annual exclusion) for dormitory fees, board, books, supplies, etc. Prepaid tuition payments may qualify for the unlimited gift tax exclusion under certain circumstances.