Submitted by Dovid Wilschanski CPA. For those who pay minimal tuition and do not receive the maximum education credit. Would you agree to a no-show, no expense job at a rate of thousands of dollars per hour? This would make you one of the highest earners in the country! Now let’s say the government pays your tuition and then additionally rewards you at that rate for taking their money if you follow certain procedures and the whole process takes a few minutes of your time, wouldn’t you do it?

Here is how it is done:-

Under a new law, a student receiving a Pell Grant, which this year is maxed out at $5,645, is permitted to allocate the grant to either tax free tuition or taxable living expenses. The allocation is without regard to the Institution’s treatment of the grant. The purpose of the allocation is that if the full Pell is allocated to tuition then the taxpayer will be ineligible for the American Opportunity ( AOTC) or the Lifetime Learning education credit because the law requires deducting from the $ 4000 maximum tuition expense eligible for the credit per student, any non taxable scholarship such as non taxable Pell grants. However, if some or all of the Pell grant is allocated to taxable living expenses, although the student will be required to report the additional taxable scholarship income, that amount will not be deducted from the $ 4000 credit-eligible amount for the AOTC leaving the parent with a potential AOTC tax credit of up to $2500 per student of which 40% is cash back from the government or $1000 per student. The mechanics of the allocation process is by simply reporting the associated living expenses as additional taxable scholarship income on the Form 1040.

An AOTC tax credit of $2500 per student is generally much more valuable than the additional taxes incurred as a result of increasing taxable income, if there would be a resulting liability.

For example:- Family Cohen consists of two parents and two children in Yeshiva or Seminary. The parents earned income is $ 35000. The tuition obligation is $4000 and the Pell awarded is $ 5645 each. If $ 4000 of the Pell is allocated to the students living expenses, the students ( not the parents ) would each report the additional $ 4000 as taxable scholarship income, which would not incur any tax. This would free up the $4000 of tuition expenses per child required for an AOTC. The combined family gain would be $2000 cash which is a handy return to the Cohens for doing the allocation. Alternatively, if the application of the Pell grant tax free to tuition expense was made by default, there would be no AOTC and no additional taxable income which means that the Cohens, for failing to optimize their benefit , would lose the $ 2000 – which is rather more than pachim ketanim.

To take a further example:- In family Levy, the parent himself attends Yeshiva or the wife a Seminary and they have a dependent child. The parent earns $31,000, tuition is $ 4000 and the Pell grant is $5645. If the parent allocates the $5645 to living expenses by reporting the additional taxable income, this frees up $4000 of the tuition to qualify for the AOTC. The new post-allocation taxable income is $ 36645 and there is an AOTC of $ 2203 netting a tax gain of $ 1164. However, if the whole Pell is allocated or defaulted to tuition, there would be no AOTC and a reduced tax but the resultant effect would be a $ 1164 tax loss for failing to optimize benefits.

The calculation to achieve optimization of benefits in this allocation wonderland is complex and a number of conflicting factors with regard to marginal tax rates based on two returns and earned income tax credit computations come into play. Increasing taxable income might be counter productive with regards to other programs tied to certain tax figures such as New Jersey Health Care eligibility rules as described in a previous article. It follows that each situation should be carefully considered in its own context with advanced tax software and a knowledgeable preparer . One size does not fit all.

In summary, the new law is designed to alleviate the financial predicament of beleaguered Pell recipients who are otherwise ineligible for the AOTC credit in an atmosphere of spiraling tuition and living costs and its benefits could be substantial if worked through correctly.

Finally, it is worthy of note that even though allocation of Pell is permitted, Form 1098T which was intended to be used in connection with the AOTC and which is required to be provided to taxpayers by January 31 has not been adjusted in the light of the changes and taxpayers should therefore be sure to mention to their preparer that a Pell grant was received which should be accordingly considered for allocation as above. Many taxpayers whose tuition is wholly paid by government programs or scholarships are not required to receive Form 1098T and are without minimal guidance about this new mechanism for qualifying for the valuable AOTC, some of which credit is refundable even without a tax liability.

Tax preparation by D.Wilschanski and Co. CPA’s is at 450 West Kennedy Boulevard Lakewood NJ. Please call 732 370-1114 for an appointment.