When Are Scholarships Taxable? It Depends on Several Rules
At least a portion of some scholarships can be taxable income.
Scholarships and grants are normally tax-free, so you can relax if you just received notice from the school of your dreams that they're tossing a bit of cash your way. But “normally” doesn’t translate to “always.” Depending on the nature of the money, how much you receive, and what you do with it, you could end up opening your pockets a little for the Internal Revenue Service. In fact, many scholarships are at least partially taxable.
What Counts As a Scholarship?
Receiving a scholarship doesn’t have to mean that someone wrote you—or your school—a check for your tuition and fees. When schools themselves give scholarships, they usually just erase what you owe for the year or semester. You effectively attend for free. These scholarships are often awarded for academic excellence or to recruit students for sports programs.
Then there are grants, sometimes called fellowship grants, which are intended to pay for a specific area of research or study. Pell Grants are an exception. They’re needs-based. The student’s economic situation is disadvantaged to the point that he would not be able to attend college without that financial help.
These sources of funding are not usually considered income, so they’re not taxable as such. But we’re talking taxes here, so insert a big “BUT…”
Where Are You Going to School?
The first qualifying rule for a tax-free scholarship addresses where you’ll be attending school. You must use the scholarship money to attend an “eligible educational institution.”
This means the institution’s primary purpose is to provide post-secondary education and instruction. It has one or more established curricula, an enrolled student body, and a facility dedicated to teaching.
This covers a large majority of schools, so it’s probably safe to assume that yours is eligible. You might want to check to make absolutely sure, however. If the school participates in the U.S. Department of Education’s student aid program, it qualifies, and the Department offers a list of these schools on its website. But don’t automatically assume that your school isn’t eligible if it doesn’t appear on the list. Contact the school to be sure.
And just intermittently taking an unrelated class or two or four won’t cut it where the IRS is concerned. You must be pursuing a degree. Otherwise, the scholarship is taxable income to you.
What Exactly Does Your Scholarship Pay For?
Now that you know that your school qualifies, you must next determine what your scholarship is intended to pay for. The funds can only be used toward “qualified educational expenses.” Otherwise, the money is taxable.
This rule might not be as clear-cut as it seems on the surface. For example, room and board is not a qualified education expense. Your scholarship is partially taxable if it pays for your tuition and fees and it also provides for a roof over your head while you’re attending classes. The IRS takes the position that the room-and-board portion of the scholarship represents income to you, at least if your scholarship designates that this is what some of the money should be used for.
Tuition money spent on required equipment, books, and supplies is tax-free. This means that your school or instructor says that you must have these things to enroll in a particular class. But if you use some of the money to voluntarily purchase a new laptop, you'll pay taxes on that portion of the scholarship.
The same goes for things like groceries, medical expenses, and insurance premiums. These costs aren’t considered qualified, either, and if you use any of the scholarship money for transportation purposes, that makes it taxable.
Did You Use All the Money?
This can be another tricky area. What if a community organization gives you a $10,000 scholarship but the qualified expenses at the school you want to attend total only $8,500? That $1,500 balance becomes taxable.
You’ll want to read your scholarship’s fine print because some private scholarship funding can be specifically earmarked to help out with non-qualified expenses. Of course, if you receive a $10,000 scholarship that’s tagged solely for tuition and fees, and if your tuition and fees are going to run you $11,500 a year, there’s no issue. Your entire scholarship is tax-free.
Did You Receive the Money in Exchange for Services Rendered?
Another issue involves why you got the scholarship or grant. Was it because you were your high school’s star quarterback? That’s fine with the IRS. The same holds true if you maintained such excellent grades that someone wanted to reward you for that. But if you receive the scholarship or grant in exchange for providing services, such as teaching, research, or even helping out in the admissions office, the money becomes taxable—or at least the portion related to payment for your services does.
The thing to watch out for here is that you were not awarded the scholarship purely because you agreed to do something in exchange for the money. Again, read the fine print. The entirety of most scholarships isn’t typically given in exchange for services rendered, but occasionally one might offer an additional $1,500 or $2,000 if you perform this or that service or job. Some grants are more likely to assert this condition. This rule applies even if you don’t have to perform the service until after you graduate.
It’s taxable income to you because you’re working for it, just as if you were being paid for any other job. In fact, you might even receive a Form W-2 for the taxable portion related to services rendered.
Some Factors Don’t Matter
Some factors will not automatically make your scholarship taxable, at least not by themselves if you meet the other rules.
It doesn’t matter what entity or individual gives you the money. The same rules apply. In fact, your grandfather can even avoid paying a gift tax if he gives the money directly to your school on your behalf.
Scholarships awarded by the Armed Forces Health Professions Scholarship and Financial Assistance Program or the National Health Service Corps Scholarship Program are exempt from the rule regarding services provided by you in exchange for the money. The same goes for many student work-learning-service programs under Section 448(e) of the Higher Education Act of 1965 and Pell Grants.
Payments received under the GI Bill aren’t considered to be scholarships or taxable income, and you won’t have to pay taxes on your scholarship if you attend school in another country simply because it’s not located on American soil. But you must meet all the other criteria.
And, of course, student loans aren’t taxable because they’re not representative of income—you have to pay that money back.