Are Merit Scholarships Taxable?

Merit scholarships offer a valuable financial resource for students pursuing higher education, helping to offset the substantial costs involved. While these awards are often perceived as entirely “free money,” their tax implications can be more nuanced. Understanding how the Internal Revenue Service (IRS) views these funds is important for students and their families to accurately manage their financial obligations. This article clarifies the conditions under which merit scholarships may or may not be subject to federal income tax.

General Rules for Scholarship Taxation

Scholarships and fellowship grants are tax-free if specific conditions are met. To qualify for tax exemption, the recipient must be a candidate for a degree at an educational institution that maintains a regular faculty and curriculum, with a regularly enrolled body of students. The funds received must be used solely for qualified education expenses. Any portion of a scholarship that does not meet these criteria is considered taxable income and must be included in the recipient’s gross income.

The tax treatment depends on how the scholarship money is spent rather than its initial receipt. While many scholarships are entirely tax-free, others may be partially or fully taxable. Students need to track their expenditures to differentiate between the tax-exempt and taxable portions of their awards.

Expenses That Qualify for Tax Exemption

For a merit scholarship to be tax-exempt, the funds must be used for “qualified education expenses” at an eligible educational institution. These expenses primarily include tuition and fees required for enrollment or attendance. Additionally, costs for books, supplies, and equipment that are specifically required for courses at the educational institution also qualify.

These qualifying expenses must be directly necessitated by the educational program and institution. For example, the cost of a textbook explicitly listed as required for a course would be a qualified expense. Conversely, a general-purpose computer or optional reading materials would not qualify for the tax exemption, even if beneficial for studies.

Scholarship Funds Subject to Tax

Any portion of a merit scholarship used for expenses beyond those considered “qualified education expenses” is subject to tax. These non-qualified expenses include, but are not limited to, room and board, travel, and other personal living costs. Even if these expenses are essential for a student’s attendance, they render the scholarship funds used for them taxable.

Scholarship amounts received as payment for teaching, research, or other services required as a condition for receiving the scholarship are also taxable. This applies even if the student uses these funds for tuition or other qualified expenses. For instance, a stipend given in exchange for serving as a teaching assistant would be considered taxable income.

How to Report Taxable Scholarships

If a portion of a merit scholarship is determined to be taxable, it must be reported as gross income on the individual’s tax return. For most taxpayers filing Form 1040 or Form 1040-SR, the taxable amount is included on the “Wages, salaries, tips” line. If the taxable scholarship income was not reported on a Form W-2, taxpayers should enter “SCH” and the taxable amount in the space to the left of this line.

Educational institutions often issue Form 1098-T, Tuition Statement, which reports amounts billed for qualified tuition and related expenses, as well as scholarships and grants received. While Box 5 of Form 1098-T shows the total scholarships and grants, this form is informational and does not directly indicate the exact taxable amount. Students are responsible for calculating the taxable portion based on their actual qualified expenses. Maintaining records of all educational expenses and scholarship disbursements is advisable for accurate tax reporting.