Taxable vs. tax-free scholarships: Key features

Earning a scholarship is a significant achievement and one of the best ways to lower the cost of college. Most scholarships are not considered taxable income, so free money shouldn’t affect you during tax season, especially if you use it for direct educational costs such as tuition, fees, textbooks or required supplies.

Be aware that using scholarship funds that are outside these educational costs may be considered taxable. The IRS defines qualified education expenses as those necessary to pay for your enrolled classes. If you have doubts about what qualifies as a nontaxable use, you may consult your scholarship grantor or your college or university’s financial aid office for clarification.

When do scholarships become taxable income?

Whether or not scholarship money is considered taxable income is based on how you use the funds. According to the Federal Student Aid Department at the U.S. Department of Education, you may need to report federal grants as income for tax purposes.

“Generally, any amount of scholarship or grant aid received that exceeds the cost of tuition, required fees, and required course materials, may be taxable,” stresses financial aid director Pam Sitting at Grinnell College.

For example, if a student receives $30,000 in scholarship money and only uses $25,000 for qualified education expenses, the remaining $5,000 may be taxable since it was used for outside expenses such as housing or food.

A tool on the IRS website can help you assess whether your grant funding may be taxable, but consulting a financial advisor may be best for accuracy.

Conditions for a tax-free scholarship

To avoid paying taxes on a scholarship, you must be:

• Actively earning a degree and regularly attending classes.
• Attending an educational institution that has a regular faculty and curriculum.
• Attending an educational institution that has a regularly enrolled body of students in attendance.
• Using the scholarship money for qualified education expenses.

If you do not fall into these categories, your scholarship may be taxable. If the money is considered payment for services required for receiving the fellowship, then the scholarship or grant would also be considered taxable.

Exceptions

Any payment received for teaching, conducting research or providing other services under an eligible student work learning-service program, such as the National Health Service Corps Scholarship Program and the Armed Forces Health Professions Scholarship and Financial Assistance Program are not taxable.

How to report a taxable scholarship

If you’re reporting a taxable scholarship — because you received payment for services or because you used the money for a nonqualified expense — you’ll typically receive a W-2 form. You’ll then report the amount listed as taxable income on line 1a of Form 1040.

Even if you don’t receive a W-2, you should still report this income on your taxes. If you don’t have this document, you’ll enter “SCH” and the taxable amount on line 8 of the 1040 form. You will also want to attach and submit the Schedule 1 form with your 1040 and other tax documents.

2 Types of taxable scholarships

1. Taxable scholarship funds

Scholarship funds tend to be taxable if you fail to meet the conditions for a tax-free scholarship listed above. Your enrollment status, institution, or how you spend the funds can impact the taxability of your scholarship money.

2. Taxable stipend scholarships

Taxable stipends are similar to other scholarships and grants. A key difference is that if you receive a stipend for living expenses or in exchange for duties performed (clerical work or research), this income will likely be considered taxable.

If you receive a W-2 form for your stipend, you’ll know the income is taxable. Otherwise, you’ll also likely receive a stipend letter from your school with information related to its taxability.

What other education tax credits and deductions exist?

College students have access to special tax credits and deductions while they’re in school or paying off loans. Here’s what you need to know about each program:

American Opportunity Tax Credit (AOTC)

Students can claim an annual maximum credit of $2,500 for the first four years of college if they meet the requirements. To get the full credit, they must have a modified adjusted gross income (MAGI) of $80,000 or less ($160,000 or less if married filing jointly). Credits are phased out for MAGIs of $80,000 to $90,000 ($160,000 to $180,000 for joint filers).

Lifetime learning credit (LLC)

This credit allows students to claim 20 percent of the first $10,000 of qualified education expenses per year (with a maximum credit of $2,000). This can apply to students of all levels; undergraduate, graduate and professional degrees can qualify with no time restriction.

To receive the full credit, borrowers’ MAGI must be below $80,000 for single filers and $160,000 for married filing jointly. The amount is phased out for borrowers with a MAGI between $80,000 and $90,000 ($160,000 and $180,000 for joint filers).

Student loan interest deduction

Students who used student loans to pay for school-related expenses may be eligible to deduct up to $2,500 in student loan interest paid during the previous year. To get the maximum amount, borrowers must have a MAGI below $80,000 for single filers and $165,000 for married filing jointly. Amounts are phased out for borrowers with a MAGI between $80,000 and $95,000 ($165,000 and $195,000 for joint filers).

Bottom line

As long as you use scholarships for their intended purpose of tuition, school fees or textbooks at a legitimate educational institution, scholarships are not taxed. You might run into situations of your scholarship turning into taxable income if you use it for other purposes like rent, or if your status as a degree candidate changes.

The IRS has provided an interactive tool online that helps students determine whether or not their scholarship money is taxable. Regardless of whether you pay taxes on scholarship money received, you might also look into education tax credits or deductions to help you save.

Frequently asked questions

• What happens if you don’t report scholarships on your taxes?
  

  If your scholarship was used toward qualifying expenses only, there is no need to report the award on your tax return. However, if you determine you’ve spent any portion of the award on taxable expenses and already filed your taxes, you’ll want to consult a tax professional about amending your return.

• Do scholarship recipients receive a 1099?
  

  Some scholarship recipients will receive a 1099; some will not– scholarship grantors are not required to report the tax-free portion of their award. Colleges are, however, must report scholarships on the 1098-T form.

• What happens if my scholarships are more than my tuition?
  

  Scholarships are factored into your overall financial aid package, so you must report any awards to your institution’s financial aid office. The scholarship income may impact your overall financial aid, including student loans.

  Check with your scholarship provider if you’ve received more money than you need to pay for direct school costs. They may have specific requirements if your aid exceeds what you need.

• Why did I receive a 1098-T form from my school?
  

  A 1098-T form is a tuition statement and should be filed for every enrolled student for whom a tax-reportable transaction is made. “Remember, taxable financial aid calculations are based on the tax year and not the academic year,” says Sittig. “The Form 1098-T provided by a college may or may not have all the information needed to calculate taxable financial aid. It is a good idea to review your billing statements for the tax year and do the calculations yourself or with the help of a tax preparer.”