When Are Scholarships Taxable? It Depends on Several Rules
Scholarships and grants aren't usually taxable, and that's good news when the school of your dreams is giving you some financial aid. But you could end up having to pay something to the IRS, depending on how much you receive and how you spend it. Some scholarships are at least partially taxable.
Scholarships from Schools
Receiving a scholarship doesn't necessarily have to mean that someone wrote you—or your school—a big check to cover your tuition and fees. Schools typically "erase" what you owe for the year or for the semester when they award full scholarships themselves rather than receiving funds from a third party. You effectively attend for free.
Scholarships offered by schools are often awarded for academic excellence or to recruit student athletes for sports programs.
Scholarships vs. Grants
Grants, sometimes called "fellowship grants," are intended to pay for a specific area of research or study. Pell grants are an exception—they're need-based. The student’s economic situation is typically so disadvantaged that they would not be able to attend college without this financial help.
These sources of funding are not typically considered income, but they're taxable under some circumstances.
Where Are You Going to School?
The first qualifying rule for a tax-free scholarship involves where you'll be attending school. You must use the money to go to what the IRS refers to as an “eligible educational institution."
This means that the institution’s primary purpose is to provide post-secondary education and instruction. It has one or more established curricula and an enrolled student body, and it maintains a facility dedicated to teaching.
The majority of schools fall under this definition, so you're probably safe in assuming that yours is eligible. One easy rule of thumb is that the school qualifies if it participates in the U.S. Department of Education’s student aid program. The Department offers a list of these schools on its website.
Don't automatically assume that your school isn't eligible, just because it doesn't appear on the Department of Education's list. Contact the school to be sure.
Intermittently taking a random class or two isn't sufficient for the IRS. You must be pursuing a degree. Otherwise, the scholarship is taxable income.
What Does Your Scholarship Pay For?
You must next determine how the scholarship funds will be used. The money can only be applied to “qualified educational expenses.” Otherwise, it's taxable.
For example, room and board aren't qualified education expenses, so a portion of your scholarship will be taxable if it pays for your tuition and fees and also provides for a roof over your head and meals. The IRS takes the position that the room-and-board portion represents income to you, which you're spending on personal needs.
Tuition money spent on required equipment, books, and supplies is tax-free. "Required" means that your school or class instructor says that you must have these items to enroll in and attend a particular class. You'd have to pay taxes on a portion of the scholarship if you were to use some of that money to voluntarily purchase a new laptop that is not required, even though you would use it for schooling.
The same goes for groceries, medical expenses, and insurance premiums. These costs aren't qualified either. It's also taxable income if you use any of the money for transportation purposes.
Did You Use All of the Money?
What if a community organization gives you a $10,000 scholarship, but the qualified expenses at the school you want to attend only total $8,500? That $1,500 balance becomes taxable income to you.
Read the fine print, too, because some private scholarship funding can be specifically earmarked for non-qualified expenses.
The flip side is that your entire scholarship would be tax-free if you were to receive $10,000 that’s tagged solely for tuition and fees, which would cost you $11,500 a year. Every dime of the scholarship would therefore go to qualified expenses, and you'll have to come up with $1,500 out of pocket for the balance besides.
Money in Exchange for Services
Why you've received the scholarship or grant is a critical factor as well. Was it because you were your high school’s star quarterback? That’s fine with the IRS. You can accept the money tax-free. The same holds true if you maintained such excellent grades that someone wanted to reward you for that.
But if you receive the funds 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. You're effectively working for it like you would for wages. In fact, you might even receive a Form W-2 for the taxable portion related to services rendered.
The thing to watch out for here is whether you are awarded the scholarship only because you agree to do something in exchange for the money. Again, read the fine print. The entirety of most scholarships is not typically given in exchange for services rendered, but one might occasionally offer an additional $1,500 or $2,000 if you perform a certain service or job.
Some grants are more likely to assert this "work for it" condition.
This rule applies even if you don't have to begin performing the service until after you graduate. It could be taxable income if you'll eventually work for it—your labor doesn't necessarily have to occur while you're enrolled.
Some Factors Don't Matter
Some factors won't automatically make your scholarship taxable, at least not by themselves and if you meet the other rules.
It doesn't matter what entity or individual gives you the money. In fact, your grandfather can even avoid paying 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.
Many student work-learning-service programs under Section 448(e) of the Higher Education Act of 1965 and Pell Grants are exempt from taxation.
Payments received under the G.I. 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. You must meet all the other criteria, however.
Student loans aren't taxable, because they aren't representative of income—you have to pay that money back.