Many tax filers are able to claim an income tax credit because they, or their dependent, incurred college education expenses. The tax benefit is typically claimed only on out-of-pocket expenses since nontaxable grants and scholarships do not qualify for the credit. However, grants and scholarships can sometimes be included in taxable income, thereby freeing up that amount to be used toward an education tax credit.

Terms of grants and scholarships

Most grants and scholarships are subject to certain terms and conditions. If nontaxable funds are required to be spent on tuition and school fees, no additional tax benefit is available. Some scholarship programs, however, may be used for food and housing. For example, the federal Pell grant can be used for the expenses of room and board.

If you or your dependent receives any education scholarships other than a Pell grant, examine the terms and conditions of those programs. As with a Pell grant, it may be beneficial to include some or all of the normally nontaxable funds as taxable income. Because a tax credit is a direct offset against income tax, the advantage of a larger education credit may outweigh any increase in taxable income.

Optimal allocation of grant and scholarship income

After considering the terms of all grants and scholarships, your tax preparer will determine how much, if any, to report as income. After all, there is a limit on the amount of education expenses that can be used to claim a credit. For the highly effective American opportunity tax credit (AOTC), only $4,000 in qualified education expenses can be used in calculating your final offset against income tax.

Interrelated tax returns

The AOTC is usually claimed by the parent of a student if the student is claimed as a tax dependent. If some portion of a grant or scholarship is considered taxable income, that increase in income is reported on the tax return of the student recipient. If the student otherwise has minimal income, there may be little or no effect on the student's income tax outcome.

As the parent of a dependent college student, you need to plan ahead to ensure that tax preparation goes smoothly for both of you. There may be enough education expenses paid out of pocket so that there is no need to even consider any grants or scholarships as taxable. Remember that current education costs paid with student loan proceeds also qualify for the AOTC.

As with many other deductions, there are overall income restrictions on who is eligible to claim an education tax credit. Contact a tax preparer like Jeffrey Beebe CPA for more advice on how to plan and prepare your personal income tax return.