Are scholarships taxable? You may be surprised that not all scholarships to pay for college are considered tax-free.
Yes, that “free” money to pay for college may be taxable according to the IRS. Shocking, isn’t it?
Scholarships are the only form of generosity that can be taxable to the recipient. If a donor contributes money to a homeless shelter or soup kitchen, the services are tax-free to the beneficiary.
But if the donor awards a grant or scholarship that covers a student’s housing and meal plan expenses, the scholarship is considered taxable income to the recipient. That’s even though more than half of college students experience food or housing insecurity according to a national survey in 2019, before the pandemic.
The tax on scholarships prevents students from making full use of their scholarships. Learn the rules concerning tax-free and taxable scholarships.
Growth In Taxable Scholarships
The number and amount of taxable scholarships reported on federal income tax returns has grown significantly in recent years. This table is based on estimates reported in the IRS Statistics of Income as well as data received from the IRS through a FOIA request (2022 is the most recent year this information is available).
IRS Taxable Scholarship Data. Source: Mark Kantrowitz
Which Scholarships Are Tax-Free?
The Internal Revenue Code of 1986, at 26 USC 117, sets several requirements for the tax treatment of scholarships. Below we break down these rules to show the differences between tax-free and taxable scholarships.
Tuition, Fees, Books, And Supplies
Generally, for a scholarship to be tax-fee, it must be used to pay for tuition and required fees, books, supplies or equipment. Only the portion of the scholarship that is used to pay for these qualified tuition and related expenses is tax-free.
If an educational institution provides a tuition waiver or tuition reduction to its faculty and staff, it is tax-free if this benefit is provided on substantially the same basis to all members of a group of employees. The group of employees must not discriminate in favor of officers, owners and highly-compensated employees.
The student must be pursuing a degree or certificate at an accredited educational institution. Otherwise, the entire amount of the scholarship is taxable.
Living Expenses
The portion of a scholarship that is used to pay for room and board, transportation, disability-related expenses, dependent-care costs and other living expenses is taxable. This includes amounts that are earmarked for living expenses, such as a living stipend, even if the recipient uses the scholarship to pay for qualified tuition and related expenses.
Fee For Services
If a scholarship is considered a fee for services, such as an employee benefit, the entire amount of the scholarship is taxable. A scholarship is considered fee for services if the services are required as a condition of receiving the scholarship. There are, however, exceptions for graduate teaching and research assistantships and certain federal health professions scholarships.
The rules above apply to all types of scholarships and grants, including private scholarships, athletic scholarships, Pell Grants and Fulbright Grants. Veterans education benefits, however, are tax-free.
Emergency Relief
Emergency financial aid grants made under the CARES Act in connection with the COVID-19 pandemic are tax-free, even if used to pay for living expenses. This provision is limited to qualified disaster relief payments for the duration of the pandemic (26 USC 139). It does not apply to other taxable scholarships.
How To Report A Taxable Scholarship
Recipients of taxable scholarships, grants, fellowships and tuition waivers during the tax year are required to report the taxable portion on their federal income tax returns.
The taxable amount of the scholarship should be reported on line 1 of IRS Form 1040. If the taxable amount of the scholarship was not reported on IRS Form W-2, write “SCH” and the taxable amount on the dotted line next to line 1.
Related: Best Free Tax Software
Workarounds For The Tax Treatment Of Scholarships
Scholarship providers have started exploring ways to award scholarships that reduce the tax impact. These include awarding the scholarship as a contribution to the student’s 529 college savings plan or through student loan forgiveness.
An added benefit is these alternatives can eliminate or reduce scholarship displacement. Scholarship displacement occurs when a college reduces the amount of its own grants after the student receives a need-based scholarship. If a scholarship is used in the calculation of the Student Aid Index (SAI), scholarship displacement cannot occur.
Normally, the taxable portion of a scholarship is subtracted from total income on the Free Application for Federal Student Aid (FAFSA). So the receipt of a scholarship does not affect the EFC. However, if a scholarship is awarded as a contribution to the student’s 529 college savings plan, which is reported as an asset on the FAFSA, it has a small impact on the SAI (increasing it by up to 5.64% of the amount of the scholarship).
Similarly, if a scholarship is awarded through student loan forgiveness after the student graduates, it does not affect the student’s eligibility for need-based financial aid.