Education tax credits, deductions and FAFSA money, oh my!

If your student received financial aid last year (or may receive funds in the coming years), they may need to report those funds on their tax return depending on how they used the money. Each financial aid award is treated a little differently, so we’ll assess each one. We’ll also take a look at higher education tax credits and deductions you should know about.

How student FAFSA money becomes taxable

Pell grants

In order for a Pell grant to remain tax-free, your student can only use the funds to pay for tuition, fees, books, supplies and equipment. However, if they use the funds to pay for housing, meals, or school-related travel expenses, then they must include the portion of the grant they used to pay these expenses in their taxable income.

Scholarships and fellowship grants

Just like a Pell grant, scholarships and fellowship grants are tax-free when used for qualified education expenses, which include tuition, enrollment fees, books, supplies and equipment required of all students. Qualified education expenses do not include the cost of housing, meals, travel, research, clerical help, optional equipment or other expenses that aren't required for enrollment.

Work-study earnings

Although your student may have been awarded Federal Work-Study to help pay for college, the money they earn at their work-study job must be reported as income just like any other employment earnings. Your student should include these earnings with their wages and salary.

Government student loans

A student loan is not considered taxable income because your student, as the recipient of the loan, has to pay it back (with interest). When they begin repayment, they may qualify for a student loan interest deduction if their income is below a certain level and they used the funds only for school-related expenses while in college. If any amount of a student loan is forgiven, that amount would become taxable income for that year.

Education tax credits and deductions

A tax credit reduces, dollar-for-dollar, any amount of money that your student owes to the government. If your student has $1,000 in tax credit and owes the government $2,000, they’ll now owe just $1,000. A tax deduction reduces the amount of their income that is subject to being taxed.

American Opportunity Tax Credit

The American Opportunity Tax Credit can be used each year of your student’s first four years of college. They must be enrolled at least half time. The credit is worth up to $2,500 per year for money paid toward tuition, enrollment fees, course-related books, supplies and equipment for attendance. It does not cover housing and meals.

Another bonus is that 40 percent of the credit is refundable — that means if your student ends up not owing anything on their taxes, they can still get up to $1,000 back. The credit will phase out for taxpayers making more than $90,000 a year on their own, or $180,000 a year for married couples. Any felony drug convictions by the end of the tax year disqualify the student from receiving this credit.

Lifetime learning credit

Another popular tax credit is the lifetime learning credit, which can be claimed by the student, the student’s spouse or the student’s parent. Your student can claim it for a deduction of up to $2,000 per household as long as they haven’t claimed another tax credit in the same year. If the taxpayer’s income exceeds $47,000, this credit doesn’t apply.

Tuition and fees deduction

This deduction applies to your student’s qualified education expenses paid during the year. The tuition and fees deduction (Form 8917) can reduce your student’s taxable income by up to $4,000. They cannot take this deduction if they are taking one of the education credits mentioned above.

Student loan interest tax deduction

If your student has been paying interest on their student loans, the student loan interest tax deduction is for them. Each year, they can deduct up to $2,500 of interest paid on qualified loans as long as they are enrolled at least half time and are working toward a degree. A qualified loan means that they borrowed their student loan solely to pay for education expenses and did not borrow the student loan from a relative or through a qualified employer plan. Examples of qualified education expenses include tuition and fees, housing and meals, books, supplies, equipment, and transportation, among other necessary expenses.

You can use the IRS’s Interactive Tax Assistant tool to help your student determine if they’re eligible for any of the education credits or deductions we covered.

That is a lot to cover, but it’s totally worth it to educate yourself and your student on any potential savings they may be entitled to. Happy filing!

Each person’s tax situation depends upon individual circumstances. The information in this article is intended to serve as introductory tax information. Please consult a tax professional for personalized tax advice.