Are Scholarships Always Tax-Free? What You Need to Know
Scholarships are generally tax-free if certain IRS and other requirements are met. Here's what you need to know about when scholarships are taxable.
Scholarships can be a valuable resource for students and their families seeking ways to fund their college education.
And now that Decision Day is coming soon, many students plan to attend their favorite colleges and universities and probably say yes to a scholarship or two.
Meanwhile, a common misconception is that scholarships are considered “free money” (i.e., they are not taxable). But that isn’t always the case — scholarship money can sometimes be taxable. Here’s what you need to know.
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When scholarships are tax-free: Qualified education expenses
When most people think of scholarships as being “free money,” they are probably referring to the tax-free portion of a scholarship. A general rule is that your college scholarship is tax-free when it is used to pay for “qualified education expenses.” For tax purposes, qualified education 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 have restrictions on what you can use the money for, so it’s good to know upfront if there are any restrictions on your scholarship money.
- Other scholarships have a wide range of allowable uses for the funds.
- However, allowable expenditures for a particular scholarship might not necessarily be the same thing as “qualified education expenses” for tax purposes — figuring it all out can get confusing.
IRS requirements for tax-free scholarships
Whether your scholarship is tax-free doesn’t depend only on qualified education expenses. The IRS has several conditions that must be met.
For example, you must be a degree-seeking candidate and attend a “qualified educational institution.” Also, to be tax-free, the scholarship cannot:
- Exceed your qualified education expenses. Sometimes, if your scholarship exceeds the amount of your qualified education expenses, you may need to report the excess amount on your tax return. So, whether your scholarship is tax-free in that example depends in part on how much scholarship money you received.)
- Be designated for other non-qualified purposes (like room and board or travel).
- Represent payment for work or services performed by you as the scholarship recipient.
Is room and board taxable?
Perhaps the most notable of these IRS requirements is that the amount of a scholarship that is used for room and board will generally be taxable.
Take for example, a situation where you receive a scholarship for $15,000 and you use $8,000 of that money to cover tuition at an eligible education institution, but you use the other $7,000 to cover room and board. The $8,000 for tuition would be tax-free because tuition is a qualified education expense. However, the $7,000 for room and board would be considered taxable income that would have to be reported on your federal income tax return.
That might seem odd because most people might think of room and board as being required for a school or educational program. However, what might be an education-related expense for you may not be considered a “qualified education expense” in the eyes of the IRS.
Are grants taxable?
Grants can be beneficial because they are typically based on need and do not require repayment of the funds. The same general rule that applies to whether scholarships are taxable also applies to grants.
If you're using grant money to cover qualified education expenses while pursuing a degree at an eligible educational institution, the funds should generally be tax-free.
Payment for work or services performed: An example of an exception to the general rule includes situations where money from a grant or fellowship essentially pays your salary.
In that case, the money could be considered taxable income, and the college or university involved would issue you a W-2. You would then report the W-2 income on your federal return. The payment for work or services performed exception may also apply to a scholarship if the scholarship money is essentially compensation for work performed by you.
Will scholarship tax change under Trump?
For now, taxes on scholarships are as described above. However, since President Trump started his second term, his administration has been working to dismantle the U.S. Department of Education. As Kiplinger has reported, that has raised questions aobut the future of everything from student loans to support for students with disabilities.
Republican lawmakers are also reportedly exploring changes to education-related tax policies, with one proposal targeting the tax-exempt status of scholarships. If embraced, that potential shift could have far-reaching implications for students and families.
- As mentioned, 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 some state-sponsored programs.
That 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.
What you can do: Education tax credits and deductions
Whether you are dealing with a scholarship or a grant, if you aren’t sure whether you spent some or all of your scholarship money on qualified education expenses, check with a trusted and qualified tax professional. They can help you sort through your expenses and assess potential tax liability. They can also see if you qualify for other tax credits and deductions to help pay for higher education.
Some federal education tax credits are highlighted below. Keep in mind that you cannot claim both of these education tax credits on a single tax return for the same student, even if you qualify for both. There are also requirements that must be met to claim either of the tax credits.
Education Tax Credits
Tax Credit | Amount | Eligibility |
|---|---|---|
American Opportunity Tax Credit (AOTC) | Maximum credit of $1,500 per undergraduate student for four years of education.The amount of the credit is 100 percent of the first $2,000 of qualified education expenses you paid for each eligible student and 25 percent of the next $2,000 of qualified education expenses you paid for that student. | The full AOTC tax credit is available for people with a modified adjusted gross income of $80,000 or less or $160,000 or less if you’re married and filing jointly. The credit amount is phased out when your income as a single filer falls between $80,000 and $90,000 and between $160,000 and $180,000 for joint filers. |
Lifetime Learning Credit: | A maximum of $2,000 per tax return that can apply to any level of student (i.e., undergraduate, graduate, professional education, etc.). | Unlike the AOTC, the lifetime learning credit isn’t limited to four years of education.The income limits and phase-outs are the same as for the American Opportunity Tax Credit. |
You can find more information on the American Opportunity Tax Credit and the Lifetime Learning Credit on the IRS website. Additionally, refer to Kiplinger's guide to the AOTC.
And...stay tuned for developments on Capitol Hill regarding education and education-related benefits, like key tax credits and scholarships.
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