IRS Topic 421: Scholarship and Fellowship Grants
Understand the tax framework for scholarships and fellowships. This guide clarifies the IRS rules that determine if student aid is considered taxable income.
IRS Topic 421 provides guidance on the tax implications of receiving scholarship and fellowship grants. These funds are not automatically exempt from income tax, as the tax treatment depends on how the money is used and the recipient’s student status. A scholarship is generally an amount paid to a student for study, while a fellowship is typically for study or research. The distinction between tax-free and taxable funds hinges on a set of conditions established by federal tax law.
Conditions for Tax-Free Scholarships and Fellowships
For a scholarship or fellowship grant to be tax-free, two conditions must be satisfied. The first is that the recipient must be a candidate for a degree at an eligible educational institution. An eligible educational institution is one that maintains a regular faculty and curriculum and has a regularly enrolled body of students in attendance where it conducts its educational activities.
The second condition relates to how the funds are spent. The money must be used for qualified education expenses, which include tuition, required fees, books, supplies, and equipment. To meet this requirement, course materials must be mandatory for all students in that specific course. Any part of the grant used for other purposes, such as room and board, travel, and optional equipment, does not qualify for the tax-free exclusion. For example, if a student receives a $20,000 scholarship and uses $15,000 for tuition and required books, the remaining $5,000 used for a dormitory is taxable.
When Scholarships and Fellowships Become Taxable
Any portion of a grant that exceeds the total cost of qualified education expenses is considered taxable income. If a scholarship provides more money than what is needed for tuition, mandatory fees, and required course materials, that excess amount must be included in the student’s gross income for the year.
A grant also becomes taxable when it is provided as compensation for services. This rule applies if the student must perform activities like teaching, research, or other work as a condition of receiving the funds. For instance, a stipend a graduate student receives for working as a teaching assistant is taxable income, and the educational institution will often report these payments on a Form W-2, just like regular wages.
There are specific exceptions to this service payment rule. Funds from the National Health Service Corps Scholarship Program and the Armed Forces Health Professions Scholarship and Financial Assistance Program are not included in gross income despite a service commitment. Payments from a comprehensive student work-learning-service program operated by a designated work college are also excluded.
How to Report Taxable Amounts
A student must report any taxable portion of their scholarship on their federal income tax return. If the taxable amount represents payment for services, the university will likely issue a Form W-2, and the income is reported as wages on Form 1040.
If no Form W-2 is issued, which is common for grant money used on non-qualified expenses like room and board, the student reports the income themselves. This taxable portion is entered on Schedule 1 (Form 1040), Additional Income and Adjustments to Income, on the line for “Scholarship and fellowship grants not reported on Form W-2.”
Students may also receive a Form 1098-T, Tuition Statement, from their educational institution. This form reports amounts paid for qualified tuition and related expenses in Box 1 and scholarships or grants in Box 5. While the Form 1098-T is a helpful reference, the student is ultimately responsible for tracking all qualified expenses and calculating the precise taxable amount.