Receiving grants and student loans to help pay for your school-related expenses can have income tax implications. Your grants and scholarships can increase your taxable income if you use the funds for personal expenses, and you can also reduce the amount of education tax credits you can claim. Your student loans, however, can provide you with many years of interest deductions when you repay them.
When you receive a government grant, such as a Pell grant, or receive a scholarship from private sources, the Internal Revenue Service doesn’t require you to include that money in your taxable income if you follow certain guidelines. First, you must enroll in a school program that eventually leads to a bachelor’s degree or higher-level degree or a training program that prepares you for full-time employment in a recognized occupation. The second requirement is that you only use the funds to pay for tuition, fees, and the books, supplies and equipment that your courses require. If you use the funds to pay for room and board or for any other personal expense, you must include those amounts in your taxable income on your return.
Taking out a student loan to pay for school doesn’t have an effect on the amount of taxable income you report during your school years. Instead, it can potentially reduce your taxable income during the years you are repaying the loans. The IRS allows you to deduct a certain amount of interest payments you make on student loans that you only use to pay school expenses. It’s not necessary for you to itemize deductions to claim it, because the IRS treats it as an adjustment to income. However, the government may reduce or entirely eliminate your deduction in years in which your income is very high. The level of income requiring a reduction of your interest deduction changes every year, but it’s usually based on your adjusted gross income before taking the interest deduction.
Tax Credit Implications
The IRS offers the American opportunity and lifetime learning credits that can reduce your tax bill on a dollar-for-dollar basis for certain school expenses you pay during the year. If you pay for school with a student loan, you can still claim the credits, because the IRS doesn’t distinguish between expenses you pay out of pocket or with a loan. However, if you do qualify for one of the credits, you cannot include the expenses you pay with grants and scholarships you receive when calculating the amount you are eligible for. For example, if your tuition this year is $10,000 and you pay for it with an $8,000 student loan and a $2,000 Pell grant, you can only include $8,000 of qualified education expenses in the credit calculation.
As part of your financial aid package, you may receive the opportunity to work part time at your school through the work-study program. Don’t confuse this with a tax-free grant even though it’s part of your Free Application for Federal Student Aid (FAFSA) award. You must include these earnings in taxable income just like you do with any other type of employment income you receive.