One of the most common questions college students and parents alike have is whether scholarships and grants are considered taxable income. With rising tuition costs, scholarships can help offset educational expenses significantly.
In this article, we’ll explain the tax treatment of different types of scholarships and grants based on IRS rules. By the end, you’ll understand whether the financial aid you receive needs to be reported on your tax return.
Defining Scholarships and Grants
Before getting into taxation specifics, let’s clarify some key terms:
Scholarships: Money awarded to students based on various merits like academic or athletic achievement, financial need, or other criteria. Scholarships don’t typically need to be repaid.
Grants: Similar to scholarships but awarded based solely on financial need. Common grant programs include Pell Grants and SEOG Grants. Like scholarships, grants don’t require repayment.
Fellowships: Money awarded for graduate or professional study/research efforts that don’t require specific services or employment duties in return.
Prizes: Awards given for achieving a specific accomplishment or task.
While scholarships, grants, and fellowships serve the same overall purpose of higher education financing, their tax treatment differs based on certain conditions. Let’s examine each type in detail.
Taxation of Scholarships and Fellowships
In general, qualified scholarships and fellowship grants used for tuition, fees, books, supplies and equipment required for coursework are tax-free. However, money received for other expenses like room and board, travel, or living expenses is considered taxable income.
- Scholarships and fellowship grants are tax-free up to the cost of attendance figure published by your school. This includes tuition, fees, supplies, equipment, and if required, books.
- Amounts exceeding the cost of attendance figure are considered taxable income. This “excess” amount must be reported on your tax return.
- Grants for room and board, travel, or other living expenses are fully taxable unless you are a degree candidate.
- Tuition reductions or waivers given to university employees may also be taxable depending on circumstances.
Be sure to obtain a 1098-T form from your university listing qualified educational expenses and scholarships/grants used to pay those costs. This form helps provide documentation for your tax filings.
Taxation of Pell Grants and Other Need-Based Aid
Pell Grants and Supplemental Educational Opportunity Grants (SEOG) are considered tax-free forms of need-based aid and don’t need to be reported on your tax return. Meanwhile:
- American Opportunity Tax Credit (AOTC) and Lifetime Learning Credit can’t be claimed in the same year Pell Grants are excluded from income.
- FAFSA EFC Grants are also fully tax-exempt as need-based financial aid.
So in summary, all federal, state, and institutional need-based grants don’t count as taxable income since these programs aim to help those most in financial need. Make sure to verify your specific program is need-based rather than merit-based which impacts tax treatment.
Taxation of prizes and awards
Any prizes and awards won due to a particular achievement, task, or accomplishment are generally taxable at their full value. For example:
- Nobel Prizes and other achievement awards exceeding $600 must be reported as “other income” on the recipient’s tax return.
- Cash awards, gift cards, certificates are all considered taxable income, regardless of if used for tuition purposes or beyond.
This tax treatment ensures fair inclusion of valuable windfalls as taxable compensation or earnings when not clearly gifts or scholarships. Non-cash awards like trophies or plaques on the other hand aren’t taxable.
Reporting Scholarships, Grants, and Tuition Reductions
Now that key definitions and tax rules are clear, reporting requirements become straightforward:
- Tax-free qualified tuition reductions and scholarships aren’t reported as income at all.
- Taxable portions like fellowships or scholarships over the cost of attendance need Form 1040 reporting as “Scholarships and fellowships” on line 1.
- Form 1040 instructions and worksheets help calculate taxable/non-taxable amounts properly.
- Form 1098-T must still be submitted to report qualified tuition and expenses regardless of taxation.
- Non-degree candidates use Form 1040 to report any grants for room/board as miscellaneous income.
By understanding what’s taxable versus non-taxable, you can accurately complete your return and claim all valid education-related credits and deductions. Proper reporting prevents surprise tax bills or audits down the road.
Other Tax Implications of Financial Aid
A few other finer points regarding the tax impact of scholarships and grants:
- Education tax credits can’t be claimed for tuition expenses covered by tax-free scholarships. This avoids “double-dipping”.
- Grant over-awards resulting in refunds are used to repay scholarships first before any excess becomes taxable income in the student’s hands.
- 529 plan withdrawal distributions are tax-free as long as used for qualified education expenses.
- 1098-T forms help identify 529 withdrawals for reporting on education credits if applicable.
- Grant funds spent on non-qualifying purchases like a computer become taxable income rather than qualified education expenses.
Always keep good records of all tuition payments, grants/scholarships received and used, as well as expenses backed by tax forms. This documentation helps the IRS verify your scholarship tax position in the event of an audit.
Some Special Situations
While the core tax treatment we’ve covered will apply in most common cases, here are some supplemental rules for certain irregular scholarship scenarios:
- Cancelled scholarships due to not meeting conditions are generally not taxable.
- Job-related scholarships reimbursing employers’ education costs are tax-free.
- Veterans education benefits aren’t taxable but work-study program earnings are subject to payroll taxes.
- Foreign scholarships for study outside the U.S. may trigger “substantial presence” rules for residency determination.
- Taxability doesn’t apply to American Indians with scholarships from tribal business earnings.
- Olympic or Paralympic athletes don’t pay taxes on prize or bonus payments related to competition wins/appearances.
In atypical situations, it’s wise to double check with a tax professional to make sure fringe cases are handled properly per IRS guidelines. Proactive research saves headaches down the road.
As you can see, the tax treatment of scholarships, grants, fellowships, and other types of financial aid can vary significantly. However, understanding the core rules—that qualified tuition reductions, scholarships up to cost of attendance, and need-based grants are generally tax-free while excess funds or living expense grants face taxation—provides a solid framework.
With careful record-keeping and reporting as outlined, students and parents can feel confident navigating these complex regulations. By utilizing available resources, asking questions to clarify any uncertainties, and documenting expenses properly, any tax liabilities or compliance issues are minimized. With informed preparation comes stress-free filing!