Are Scholarships Taxable in California?

California’s tax rules for scholarships mirror federal law. The taxability of scholarship funds depends on how the money is spent, not on the award’s source. If the Internal Revenue Service (IRS) considers a portion of a scholarship to be taxable income, the California Franchise Tax Board (FTB) does as well. The distinction is between funds used for required educational costs and those used for other expenses.

Federal and California Tax Rules for Scholarships

For a scholarship to be tax-free, it must be a “qualified scholarship” by meeting three conditions. First, the recipient must be a candidate for a degree at an eligible educational institution. Second, the scholarship or fellowship grant cannot be a payment for services, such as teaching or research. Third, the funds must be used for qualified education expenses.

An eligible educational institution is any college, university, vocational school, or other post-secondary institution that is eligible to participate in a student aid program administered by the U.S. Department of Education. This includes the vast majority of accredited public, nonprofit, and private for-profit institutions.

Qualified education expenses are costs required to attend the institution. These include tuition, mandatory fees, and course-required books, supplies, and equipment. For these materials to qualify, their purchase must be mandated by the instructor for all students in that class.

Any portion of a scholarship used for non-qualified expenses is taxable income. These include:

• Room and board
• Travel
• Research costs not required for a course
• Clerical help
• Equipment not explicitly required for enrollment

For example, if a student receives a $25,000 scholarship and uses $20,000 for tuition and required books, but the remaining $5,000 for a dorm room, that $5,000 is taxable income at both the federal and California state levels.

Tax Treatment of Specific Aid and Payments

The source and purpose of financial aid can alter its tax treatment. Funds that require a student to perform work are considered compensation and are taxable. For instance, a grant that requires a student to serve as a teaching or research assistant is payment for services and will be taxed as wages. Federal Pell Grants are need-based and are tax-free as long as the grant money is spent on qualified education expenses.

An employee can receive up to $5,250 per year from their employer for educational expenses tax-free. This assistance must be provided under a written educational assistance program. Through the end of 2025, this tax-free benefit also includes employer payments made toward an employee’s student loan principal or interest, subject to the same combined $5,250 annual limit. Any amount provided above this threshold is considered taxable wages.

Qualified tuition reduction programs offered by educational institutions for their employees, spouses, and dependents are also not taxable. These programs reduce the amount of tuition an employee or their family member must pay. This exclusion applies to undergraduate education and, for employees engaged in teaching or research activities, can also apply to graduate-level studies.

Reporting Taxable Scholarship Income

To determine the taxable portion of a scholarship, subtract the total amount spent on qualified education expenses from the total scholarship funds received. The remainder is the amount that must be reported as taxable income.

On a federal return, if no Form W-2 was issued for the funds, this taxable portion is reported on Schedule 1 (Form 1040), “Additional Income and Adjustments to Income,” on the line for “Scholarship and fellowship grants.” This total then flows to the main Form 1040.

Because California’s tax law conforms to federal rules, the federal Adjusted Gross Income (AGI), which already includes the taxable scholarship amount, is the starting point for the California Form 540. No separate adjustment is needed on the state return for this income.

The informational Form 1098-T, provided by the educational institution, is a helpful tool for calculating tuition and fees. However, it may not include all qualified expenses like required books and supplies, which must be tracked separately.

Record-Keeping for Scholarship Expenses

Students receiving scholarship funds should keep records to prove the money was used for qualified education expenses. This documentation is needed to defend the scholarship’s tax-free status in an audit by the IRS or the FTB. Without proper documentation, a tax authority could reclassify tax-free funds as taxable income.

Important documents to retain include:

• Receipts for tuition and all mandatory fees paid to the institution
• Invoices and receipts for required books, supplies, and equipment, showing the cost and date of purchase
• Course syllabi, official university book lists, or correspondence from instructors that lists mandatory items
• Bank or credit card statements that show the corresponding payments for these expenses

The California Franchise Tax Board has four years to audit a return, while the IRS generally has three. Therefore, it is wise to keep these records for at least four years after filing.