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Advice for Grads - Paying taxes on your fellowship












So, you've gotten a fellowship -- congrats!  However, one tricky part about fellowships is that taxes are not automatically deducted from the fellowship stipends you receive.  So, for example, if you get a $20,000 fellowship, you will receive all $20,000.  This does not mean that your fellowship is non-taxable!  In fact, most of the standard fellowships a zoology grad student here would recieve (College of Natural Science Recruiting Fellowship, University Distinguished Fellowship, and NSF fellowships) have taxable portions.  Because of this, you will need to make sure to report your fellowship income on your federal, state, and city (if you live in Lansing) tax forms. 

In addition, you might need to pay what are known as estimated taxes on your fellowship income.  I'll address these issues separately below. 

Disclaimer:  I don't claim have 100% knowledge of these issues, and I don't really want the IRS to come after me for misreporting information.  :)  Please make sure to read the appropriate federal, state, and city tax forms to make sure that you are correctly handling and reporting your taxes. 

What is the taxable portion of my fellowship? 

For official and detailed information from the IRS on this topic, go here.  Below, I present a brief summary and example of this that is geared toward the typical scenario that a MSU zoology grad student might face.

Taxable = The stipend you receive, minus the money you spend on required materials for your courses (i.e. required textbooks).  The stipend here refers to just the money that you will actually receive from the fellowship; it does NOT include any money that the fellowship contributes toward your tuition and fees. 

Nontaxable = The money that you spend on required materials for your courses, plus the money that your fellowship contributes to qualified educational expenses (i.e. tuition). 

Example:  You received a fellowship for $20,000 in 2006.  Over the course of the year, you received $20,000 for your stipend, and used that money for your apartment rent, transportation, groceries, vision and dental coverage, and for miscellaneous expenses.  The fellowship also contributed $8,000 for the credits you enrolled for over the course of the year.  You spent $100 of your "own" money for textbooks for those credits.  The taxable portion of your fellowship is therefore $20,000 - 100, or $19,900.  This is the amount that you would report on your 2006 tax forms. 

How/Where do I report the taxable portion of my fellowship income on my tax forms?

Good question...it took me awhile to figure this out, too.  For the official answer from the IRS, go here.  That information is geared toward the federal income tax forms.  Follow analogous instructions for your state and city tax forms. 

What are estimated taxes, and why should I care?

If you are receiving a fellowship, you will probably need to pay what are known as "estimated taxes."  The basic concept is this:  the governments (federal, state, and  city) want your money as soon as possible so that they can gather interest on it.  This is why typical jobs (including a TA or RA position) will automatically deduct taxes from each of your paychecks -- so that the goverment can have that money asap.  For whatever reason, as I discussed above, taxes are not automatically deducted from your fellowship stipend, but your stipend is still taxable...and the government wants that money sooner than the yearly April 15th deadline! 

Estimated taxes are the government's way to gather taxes on your fellowship stipend throughout the year.  If you are required to pay estimated taxes, then you pay them at four times throughout the year:  April, June, September, and January.  The basic idea is that you are estimating the taxes that you'll owe throughout the year and paying that amount over four increments during the year. 

Now, you could just wait until your tax returns are due (on April 15 each year) to pay the taxes that you owe from your fellowship.  But the government will only let you get away with that once (during the first calendar/tax year you received the fellowship; it considers your sudden accumlation of stipend as a windfall).  If you have a fellowship during a second calendar/tax year, then you will most likely need to begin to pay estimated taxes at the beginning of that year (starting in April when your tax return for the previous year is due).  If you don't begin to pay estimated taxes at that point, you might have to pay a hefty penalty later. 

Do I need to pay estimated taxes? 

If you have a fellowship, then the short answer is "probably."  You can find out for sure by reading here (a section of publication 505 from the IRS; this publication is one year old).    

How much do I owe for my estimated taxes?

For the detailed and official instructions/worksheet from the IRS, go here (note: this is a year old).  Here's my colloquial summary:

To calculate how much you will owe for estimated taxes in the upcoming tax year, you can use one of two valid strategies: 

  1. (General idea):  Estimate how much tax (after withholding; the portion that will NOT be deducted automatically throughout the year) you will owe for the upcoming year.  This is your estimated tax for that year; divide by four to get the amount you should pay for each of your four increments (due in April, June, September, and January). 

  2. (General idea):  Calculate the TOTAL tax that you owed for the previous year (NOT simply the amount that you paid to the IRS in April, but rather the TOTAL tax that you owed throughout that year).  Use THIS amount as your estimated tax for the upcoming year; divide by four to get the amount you should pay for each of your four increments (due in April, June, September, and January). 

Now, which is the better strategy?  Well, it depends.  I stick with strategy number 2, for a few reasons.  First, strategy 1 requires you to guess how much fellowship money you will receive over the upcoming year.  Sometimes you know this in advance; other times you might not (for example, will you or won't you get that cushy NSF fellowship that you applied for?).  It "safer" to not have to guess (in other words, to use strategy 2) because if you underpay your estimated taxes by a significant amount, you can get a penalty.  Second, in many cases, the fellowship money that you will receive in the next year is greater than the fellowship money that you received over the previous year.  By paying estimated taxes based on the taxes you owed for the previous year (strategy 2), you are paying less throughout the year, which means that you can hold more of the money for yourself (to pay bills and/or generate interest on) for a longer period of time.  But BOTH strategies require you to pay the same amount of money in the end

But NOTE that when you pay estimated taxes for year xxxx, when it comes time to file your regular income tax forms for year xxxx (in April of year xxxx+1), that form will "balance things out" so that no matter which strategy you used, you will end up paying the same amount of money.  If your estimated tax strategy caused you to overpay for year xxxx, then filing your xxxx annual tax return will result in you getting a refund.  If your estimated tax strategy caused you to underpay for year xxxx, then filing your xxxx annual tax return will result in you having to pay the leftover balance then.  So, BOTH strategies require you to pay the same amount of money in the end.  Which strategy you use depends on whether or not you want you or the government to accumulate interest on some of the money throughout the year (or, alternatively, whether you want to owe more money or get a refund when you file taxes in the following April). 

When do I file estimated taxes?

You begin to file your estimated taxes for year xxxx when you file your annual taxes for year xxxx-1 (in April of year xxxx), and then three other times (in June, September, and January) over the next year. 

For example, if you will need to pay estimated taxes for 2007 because you'll have fellowships that year, you should file your normal 2006 tax form in April of 2007, and you should also file the first 2007 estimated tax form then.  You should file your additional 2007 estimated tax forms in June of 2007, September of 2007, and January of 2008. 

What tax forms will I need to fill out to pay my estimated taxes?

To pay estimated taxes for year xxxx, you will need the federal, state, and city (if you live in Lansing) estimated tax forms. 

Federal form:  Year xxxx IRS form 1040 ES.  (Attached is the 2006 Federal form, plus instructions).

State form:  Year xxxx [state] form 1040 ES.  (Attached is the 2006 MI form, plus instructions).

City form:  Year xxxx [city] form 1040 ES.  (For the Lansing form, if you live in Lansing, pick one up from a Lansing post office in the beginning of year xxxx).