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, which is good news if the school of your dreams is tossing a bit of cash your way. However, depending on how much you receive and how it is spent, you could end up having to pay something to the IRS. In fact, many scholarships are at least partially taxable.
What Counts As a Scholarship?
Receiving a scholarship does not have to mean that someone wrote you—or your school—a check for your tuition and fees. When schools award scholarships, they typically 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.
Grants, sometimes called fellowship grants, are intended to pay for a specific area of research or study. Pell grants are an exception; they are need-based, and the student’s economic situation is disadvantaged to the point that they would not be able to attend college without financial help. These sources of funding are not typically considered income, but there are some circumstances where they are taxable.
Where Are You Going to School?
The first qualifying rule for a tax-free scholarship concerns where you will be attending school. You must use the scholarship money to attend what the IRS defines as 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.
A majority of schools fall under this definition. Therefore, it is probably safe to assume that your school is eligible. 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 do not automatically assume that your school is not eligible if it does not appear on the list. Contact the school to be sure.
Intermittently taking a class or two is not sufficient for the IRS. You must be pursuing a degree. Otherwise, the scholarship is taxable income.
What Exactly Does Your Scholarship Pay For?
Once you determine what your school qualifies for, you must determine how your scholarship will be used. The funds can only be used toward “qualified educational expenses.” Otherwise, the money is taxable.
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 are 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 as a qualified expense.
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 will pay taxes on that portion of the scholarship.
The same goes for groceries, medical expenses, and insurance premiums. These costs are not qualified either, and if you use any of the scholarship money for transportation purposes, it is taxable.
Did You Use All the Money?
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.
Read your scholarship’s fine print because some private scholarship funding can be specifically earmarked for 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, your entire scholarship is tax-free.
Did You Receive the Money in Exchange for Services Rendered?
Why did you receive 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 is not typically given in exchange for services rendered but, occasionally, one might offer an additional $1,500 or $2,000 if you perform a service or job. Some grants are more likely to assert this condition.
This rule applies even if you do not have to perform the service until after you graduate. It could be taxable income if you are 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 Do Not Matter
Some factors will not automatically make your scholarship taxable, at least not by themselves if you meet the other rules.
It does not 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 G.I. Bill are not considered to be scholarships or taxable income, and you will not have to pay taxes on your scholarship if you attend school in another country, but you must meet all the other criteria.
Student loans are not taxable because they are not representative of income—you have to pay that money back.