When Are Scholarships and Grants Taxable?
Understand the tax implications of your financial aid. The taxability of scholarships and grants often depends on how the funds are used by the student.
Scholarships and grants are a source of funding for many students pursuing higher education, but this financial aid is not always tax-free. The Internal Revenue Service (IRS) has specific regulations that determine whether these awards constitute taxable income. Failing to properly account for taxable scholarship or grant money can lead to unexpected tax liabilities.
Conditions for Tax-Free Scholarships and Grants
For a scholarship or grant to be entirely tax-free, a student must meet two primary conditions set by the IRS. The first is that the student must be a candidate for a degree at an eligible educational institution. A degree candidate is a student who attends a primary or secondary school, or is pursuing a college or university degree.
An eligible educational institution is defined by the IRS as one that maintains a regular faculty and curriculum and has a regularly enrolled body of students in attendance. This definition covers nearly all accredited public, nonprofit, and private for-profit colleges and universities.
The second condition is that the scholarship or grant money must be used to pay for qualified education expenses. These expenses are limited to tuition and fees required for enrollment or attendance, along with books, supplies, and equipment that are required for courses. The expense must be a mandatory condition for enrollment or for a specific course of instruction.
It is the student’s responsibility to track how the funds are used and ensure they are allocated to these qualified costs. Any amount of a scholarship or grant not used for these specific expenses may be subject to income tax.
Identifying Taxable Scholarship and Grant Income
Any portion of a scholarship or grant used for expenses other than qualified education expenses is considered taxable income. These non-qualified expenses include some of the largest costs associated with college, such as room and board, travel, and optional equipment. For instance, if a student receives a $20,000 scholarship and has $14,000 in tuition and required fees, the remaining $6,000 is taxable if used to cover living expenses.
A simple way to determine the taxable portion is to subtract the total qualified education expenses from the total scholarship and grant money received. If the result is a positive number, that amount represents gross income that must be reported to the IRS.
A separate rule applies to funds received as payment for services. Any amount a student receives that is designated as payment for teaching, research, or other services is taxable income. This holds true even if these duties are a condition for receiving the scholarship or grant.
Often, the educational institution will report these payments on a Form W-2, Wage and Tax Statement. In such cases, the income is clearly defined as wages and must be reported on the student’s tax return accordingly.
How to Report Taxable Amounts to the IRS
When a student determines they have taxable scholarship income that was not reported on a Form W-2, they must report it on their federal income tax return. The taxable amount is included on Schedule 1 (Form 1040), Additional Income and Adjustments to Income.
Students will receive a Form 1098-T, Tuition Statement, from their educational institution. This form reports payments received for qualified tuition and related expenses (Box 1) and the total of all scholarships or grants administered by the institution (Box 5). While this document is a useful starting point, the figures on it do not definitively determine the taxable portion of a scholarship.
If a student anticipates a significant tax liability from their scholarship income and no taxes are being withheld, they may need to make estimated tax payments throughout the year. This is done using Form 1040-ES, Estimated Tax for Individuals. Making these quarterly payments helps avoid a large tax bill and potential underpayment penalties when the annual tax return is filed.
Essential Record-Keeping for Students
Maintaining records is necessary for substantiating tax positions related to scholarships and grants. Students should retain copies of all official scholarship and grant award letters. These documents establish the amount, source, and any specific terms of the financial aid received.
It is also important to keep detailed receipts and bank statements for all qualified education expenses. For course materials, having a copy of the syllabus that specifies the mandatory items provides strong evidence. Important records to keep include:
- Official scholarship and grant award letters
- Receipts and canceled checks for all qualified education expenses
- Bank statements showing proof of payment for expenses
- A copy of the syllabus or course requirement list specifying mandatory items
These records serve as the primary proof to support the figures reported on a tax return. In the event of an IRS inquiry or audit, this documentation will be necessary to demonstrate that scholarship funds were used for qualified expenses.