Navigating the Tax Landscape of Scholarships and Grants

Scholarships and grants are invaluable resources for students and families navigating the financial complexities of higher education. As Decision Day approaches and students eagerly accept scholarship offers, it's crucial to understand the tax implications associated with these funds. A common misconception is that scholarships are always "free money" and therefore not taxable. However, this isn't always the case, as scholarship money can sometimes be subject to taxation.

Understanding Tax-Free Scholarships: Qualified Education Expenses

Many people associate scholarships with "free money," primarily referring to the tax-free portion of a scholarship. Generally, a college scholarship is tax-free when used to cover "qualified education expenses." For tax purposes, these expenses typically include tuition, fees, books, and supplies.

Another general guideline is that qualified education expenses are typically limited to items required for all students to attend a particular institution. For example, if you choose to spend money on supplemental items that are not required for a course or by your college or university, those items would generally not be considered “qualified education expenses" by the IRS.

Some scholarships may have specific restrictions on how the money can be used, so it's essential to understand these limitations upfront. Other scholarships may have a broader range of allowable uses. However, it's crucial to remember that allowable expenditures for a particular scholarship might not necessarily align with "qualified education expenses" for tax purposes, which can be confusing.

IRS Requirements for Tax-Free Scholarships

Whether a scholarship is tax-free depends not only on qualified education expenses but also on several conditions set by the IRS.

Degree-Seeking Candidate at a Qualified Institution

The recipient must be a degree-seeking candidate attending a "qualified educational institution." This refers to an institution with a regular faculty and curriculum and a regularly enrolled body of students.

Scholarship Amount and Qualified Expenses

To be tax-free, the scholarship cannot exceed your qualified education expenses. If the scholarship amount exceeds these expenses, the excess amount may need to be reported on your tax return. Therefore, tax-free status depends partly on the amount of scholarship money received.

Designated Purpose of the Scholarship

The scholarship cannot be designated for non-qualified purposes like room and board or travel.

Payment for Services

The scholarship cannot represent payment for work or services performed by the recipient.

The Taxability of Room and Board

One of the most important IRS requirements is that any scholarship amount used for room and board is generally taxable. For example, if you receive a $15,000 scholarship and use $8,000 for tuition (a qualified education expense) and $7,000 for room and board, the $8,000 would be tax-free, while the $7,000 for room and board would be considered taxable income and must be reported on your federal income tax return.

Read also: Unlock Ball State Funding

This distinction may seem odd, as room and board are often considered necessary for attending school. However, the IRS may not consider all education-related expenses as "qualified education expenses."

Tax Implications of Grants

The same general rules that apply to scholarships also apply to grants. If you use grant money to cover qualified education expenses while pursuing a degree at an eligible educational institution, the funds are generally tax-free. Grants can be beneficial because they are typically based on need and do not require repayment.

Payment for Work or Services Performed

An exception to the general rule exists when grant or fellowship money essentially pays your salary. In this case, the money may be considered taxable income, and the college or university will issue a W-2 form. You would then report this income on your federal tax return. This exception also applies to scholarships if the money is essentially compensation for work performed.

Potential Changes to Scholarship Taxation

Republican lawmakers are reportedly exploring changes to education-related tax policies, including the tax-exempt status of scholarships. If these changes are embraced, they could have significant implications for students and families. Currently, scholarships and fellowships used for qualified educational expenses are not subject to federal income tax. However, a proposed system could introduce tax on various forms of educational financial assistance, possibly including state-sponsored programs. This could significantly affect college affordability, particularly for families who depend on scholarships to fund higher education. Under the potential new approach, scholarship funds that are currently tax-free when applied to tuition and required course materials might be reclassified as taxable income for students. According to proposals being floated by the House Budget Committee, Republicans estimate that they can save $54 billion over 10 years by eliminating the exclusion of scholarship and fellowship income from taxation.

Education Tax Credits and Deductions

If you're unsure whether you spent some or all of your scholarship money on qualified education expenses, consult a qualified tax professional. They can help you sort through your expenses and assess potential tax liability. They can also determine if you qualify for other tax credits and deductions to help pay for higher education.

American Opportunity Tax Credit (AOTC)

The American Opportunity Tax Credit (AOTC) offers a maximum credit of $1,500 per undergraduate student for four years of education. The credit equals 100% of the first $2,000 of qualified education expenses paid for each eligible student, plus 25% of the next $2,000 of expenses. The full AOTC is available for individuals with a modified adjusted gross income (MAGI) of $80,000 or less, or $160,000 or less if married filing jointly. The credit amount is phased out for single filers with incomes between $80,000 and $90,000 and for joint filers with incomes between $160,000 and $180,000.

Lifetime Learning Credit

The Lifetime Learning Credit provides a maximum of $2,000 per tax return and can be applied to any level of student (undergraduate, graduate, professional education, etc.).

It's important to note that you cannot claim both the AOTC and the Lifetime Learning Credit on a single tax return for the same student, even if you qualify for both. Additionally, certain requirements must be met to claim either credit.

Other Potential Deductions and Savings Programs

Student Loan Interest Deduction: For 2025, the amount of your student loan interest deduction is gradually reduced (phased out) if your MAGI is between $85,000 and $100,000 ($170,000 and $200,000 if you file a joint return). You can’t claim the deduction if your MAGI is $100,000 or more ($200,000 or more if you file a joint return).
Education Savings Bond Program: For 2025, the amount of your education savings bond interest exclusion is gradually reduced (phased out) if your MAGI is between $99,500 and $114,500 ($149,250 and $179,250 if you file a joint return). You can’t exclude any of the interest if your MAGI is $114,500 or more ($179,250 or more if you file a joint return).
Achieving a Better Life Experience (ABLE) Account: This savings account is for individuals with disabilities and their families. Distributions are tax-free if used to pay the beneficiary’s qualified disability expenses, which may include education expenses.

Key Considerations for Students and Families

Filing Requirements

If a student's taxable income exceeds $12,950, they are required to file a tax return, even if their parents still claim them as a dependent.

Private Scholarships and Living Expenses

Since private scholarships often have lenient rules about how funds can be used, it's important to know in advance that you might face tax penalties if you're using private scholarship funds to pay for extra living expenses, technology, or travel costs. In addition, stipends or cash payments received in addition to the scholarship and used for non-tuition expenses will be considered taxable.

Form 1098-T

Typically, at the end of January, your campus should issue a summary (Form 1098-T) of what financial aid was applied to your tuition and a total of all scholarships and grants received on your behalf.

Coordination with Financial Aid Office

If you receive private scholarships that can be used for living expenses, let your college financial aid office know.

529 College Savings Plan

Finally, you and your family may also want to explore putting funds into your state’s 529 college savings plan.

Special Situations

Graduate Student Funding

Graduate student funding tends to be a gray area in terms of taxation. In some cases, a scholarship is really more of a stipend, providing compensation for services while you’re in school or for services you’ll provide in the future. If you receive a scholarship with the condition that you provide services in the future, you’ll need to count the scholarship as income in the year you receive it. This is obviously contingent on how your funding is structured, so it’s important to talk with your financial aid office before committing to an offer.

Athletic and Music-Performance Scholarships

The rules in this area are continuing to evolve, but currently these amounts are generally exempt from tax, even if the school reasonably expects the student to participate in a particular activity. Generally, the scholarship must continue even if the recipient is injured or simply chooses not to participate.

GI Bill Payments

Notably, the IRS has said that payments made through the GI Bill aren't considered to be scholarships, so they don't constitute taxable income.

Kiddie Tax

The kiddie tax may throw an extra wrinkle in the rules for taxing scholarships. Be careful to avoid adverse tax consequences. Briefly stated, the kiddie tax applies to "unearned income" above an annual threshold that's received by a dependent child under age 19 or a full-time student under age 24. If the kiddie tax comes into play, the excess is taxed at the top tax rate of the child's parents - not the child's tax rate - regardless of the source of the income. However, if a scholarship is used for purposes other than for qualified expenses, the amount is generally considered to be unearned income.

Resources and Forms

Form 1098-T, Tuition Statement: This form provides information about tuition payments and scholarships received.
Form 8863, Education Credits (American Opportunity and Lifetime Learning Credits): This form is used to claim education tax credits.
Form 8862, Information To Claim Certain Credits After Disallowance: This form may be required if your American opportunity credit was denied or reduced for any reason other than a math or clerical error for any tax year beginning after 2015.
Form 4547: Form for making elections related to Trump accounts.

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