Generally, scholarships are tax free and reduce the amount of education expenses available to claim an education credit. However, a scholarship is not treated as tax free when:
It may be advantageous for the student to include the scholarship in his or her income so more expenses can be used to claim an education credit.
Example 1. Jack paid $4,000 for tuition in 2014. He received a $4,000 scholarship that by its terms allow it to be used to pay any education expenses. If Jack does not include the scholarship in his income, then the scholarship would offset Jack’s qualified education expenses to $0 ($4,000 tuition - $4,000 tax free scholarship). In this instance Jack cannot claim an education credit because there are no qualifying education expenses left over.
Example 2. Assume the same facts as in Example 1, except that Jack does include the scholarship in income. The scholarship is now taxable income and will not be used to offset Jack’s qualified education expenses. Jack can now use the entire $4,000 of tuition paid to claim an education credit.
TaxACT does not make this calculation for you. To determine if including scholarship amounts in income would be advantageous in your situation, you must manually enter the amount of scholarship income used for unqualified expenses. Do this during the Student Information topic in the Federal Q&A. After you enter scholarship income, TaxACT will ask you how much of the scholarship was used for unqualified expenses.
This provision also works for parents claiming a student as a dependent. The student can include the scholarship in his or her income, which may allow the parent to claim a higher education credit. In this case, you must compare the benefit of the parent getting a higher education credit to the additional amount of tax, if any, that is due on the student’s return.