Are Scholarships Taxable? Here's How to Know If Yours Is Tax-Free
Image: Bigstock
If you received a scholarship or grant for college, you might assume it is completely tax-free. That is often true, but not always. Whether scholarship money counts as taxable income depends less on who gave it to you and more on how the money is used. Some students are surprised at tax time to learn that part of their award needs to be reported to the IRS.
The basic rule is simple: scholarships used for required education costs are usually tax-free, while money spent on living expenses or paid in exchange for work is often taxable. Understanding this distinction can help you avoid filing mistakes and even plan to lower your overall tax bill.
When Scholarship Money Stays Tax-Free
Most scholarships and grants are not taxed as long as a few conditions are met. First, you must be a degree-seeking student. This includes K-12 school students and those in colleges working toward an associate, bachelor’s or higher degree. The school itself must also qualify, meaning it is accredited and legally authorized to offer degree programs or career training.
Next comes the most important factor: how the money is spent. Scholarship funds remain tax-free only when they are used for qualified education expenses. These generally include tuition and fees required for enrollment. In many cases, required books, supplies, and equipment also qualify, but only if they are mandatory for all students in your course or program.
If your scholarship covers only these costs and nothing more, it usually will not count as income on your tax return.
Expenses That Can Make a Scholarship Taxable
Problems arise when scholarship money goes beyond qualified education expenses. Any portion of your award used for room and board, housing, utilities, transportation, or other living costs is typically taxable. The same applies to optional supplies or equipment that are not required for your courses.
For example, if your tuition and required fees total $10,000 and your scholarship is $12,000, the extra $2,000 is generally considered taxable income if it is used for non-qualified expenses. Even if the school deposits the money directly into your account, the IRS still looks at how it was used.
When Scholarships Act Like Paychecks
Some scholarships are tied to work obligations, which changes how they are taxed. If part of your award is payment for teaching, research or other services, that portion is usually taxable. Graduate students often encounter this with stipends or assistantships.
For instance, if a scholarship provides $5,000 and requires you to teach classes worth $1,500, that $1,500 typically counts as taxable income. The remaining amount may still be tax-free if it is used for qualified education expenses.
There are a few narrow exceptions, such as certain health or military scholarship programs, but most service-based awards should be treated like income.
Scholarships vs. Grants: Is There a Difference?
From a tax perspective, scholarships and grants are treated very similarly. Scholarships are often merit-based, while grants are usually need-based, but neither has to be repaid. Pell Grants are a common example of federal aid that is usually tax-free when used for tuition and other required expenses.
Just like scholarships, grants can become taxable if they are used for non-qualified costs. The name of the aid matters less than how the money is spent.
Education Tax Credits Can Change the Math
Scholarships are not the only tax break available to students and families. Education tax credits can also reduce the cost of college, sometimes significantly.
The American Opportunity Credit is available to eligible students during their first four years of college. It can be worth up to $2,500 per student per year and even includes a refundable portion. The Lifetime Learning Credit is broader and applies to degree programs, job training, and continuing education, offering up to $2,000 per return.
Using Taxes Strategically to Your Advantage
In some cases, it may actually make sense to treat part of a scholarship as taxable income. By using some scholarship funds for living expenses instead of tuition, you may free up qualified education expenses that can be used to claim an education tax credit.
For example, if a scholarship covers all tuition and books, you normally would not qualify for the American Opportunity Credit. But if you report part of that scholarship as taxable income and use it for non-qualified costs, you may be able to claim the credit. Because part of the American Opportunity Credit is refundable, this strategy can sometimes result in a net tax benefit.
How to Report Taxable Scholarship Income
If any part of your scholarship is taxable, it needs to be reported on your federal tax return. For most taxpayers, the taxable portion is included in total wages or income on Form 1040. If it was not reported on a W-2, it is typically listed on Schedule 1.
Keeping records of how scholarship money is used can make this process much easier and help support your return if questions come up later.