If you are parent whose children have not yet started college, you may be shocked when the college search begins, and the associated costs become clear. Costs to attend some colleges are approaching astronomical levels. Thankfully, there is a good amount of information out there if you know how to find it.

If you’re ahead of the game and planning early, you might take advantage of planning articles like this or a recent review of 529 College-Savings Plans put out by Morningstar Advisors.

But for those already in the thick of it -– with children attending college now — here is some advice from a recent Smart Money article about financial aid and taxes.  The article addresses the question of just how taxes play out in relation to financial aid.

First, it depends on the nature of the aid: is it gift aid or is it offered as the payment for work?

Gift aid is essentially that money which the student doesn’t need to work for, including “scholarships,” “fellowships,” “grants,” “tuition discounts,” or “tuition reductions.”  This money is not taxed so long as the recipient is eligible for a degree (including graduate degrees), the money is demonstrably going toward expenses (if it comes in the form of funds), and the associated costs are demonstrably higher than the received aid (and the recipient incurs those costs in the same time-period.)  Any leftover gift aid, however, is taxable.

If the aid comes in the form of payment for work, as in the federal work-study program or in teaching assistance for the university, then the aid is also taxable, at least in principle.  Receiving taxable financial aid doesn't necessarily mean owing anything to the IRS.  Here's why:  A student who is not a dependent can offset taxable income with his personal exemption – $3,650 for 2010; $3,700 for 2011 – and his standard deduction – $5,700 for 2010; $5,800 for 2011 (assuming the student is unmarried). So a non-dependent student would not owe any federal income tax if his income from taxable sources was $9,350 or less for 2010 or $9,500 or less for 2011.

A dependent child is still your dependent and therefore is not entitled to a personal exemption deduction (you claim it on your return).  But your child’s standard deduction will still shelter up to $5,700 of earned income in 2010 (or up to $5,800 in 2011).

Finally, if you don't claim your child as a dependent on your return, he or she can probably reduce or eliminate any federal income tax bill by claiming the American Opportunity tax credit (worth up to $2,500) or the Lifetime Learning tax credit (worth up to $2,000).

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