Are Scholarships Taxable? Everything You Need to Know

Paying for a college education with scholarships is an amazing opportunity. Since scholarship money doesn’t have to be paid back, it allows students to graduate with less debt by making it easier to avoid student loans. But many students (and parents) wonder, do you have to pay taxes on scholarships? Or are scholarships tax-free?

Taxes are always a complicated issue, mainly because every household’s situation is different. But when it comes to scholarships and taxes, there are only two scenarios students, and their families need to contend with, making it simpler to figure out whether the Internal Revenue Service (IRS) considers the award income.

Ultimately, scholarships are a cost-effective option, even if your student has to pay taxes on the money. If you or your student are confused about scholarships and taxes, here’s everything you need to know.

If you and your student want to learn more about where to find and how to land scholarships, attend our free college scholarship webinar! Head to https://thescholarshipsystem.com/webinar to sign up.

Do You Have to Pay Taxes on Scholarships?

When your student lands a scholarship, two scenarios can play out. In one case, the answer to the “are scholarships taxable” question is no. In the other, the answer is yes. That’s what makes scholarships and taxes so confusing.

To qualify for tax-free scholarships, the recipient must generally be a candidate for a degree at an eligible educational institution, such as a primary, secondary, or post-secondary college.

However, which side of the line your student’s scholarships fall on is pretty cut and dry. Taxes on scholarships are based on how the money is used. That means all awards can potentially be tax-free scholarships. However, it also creates a situation where any award could be subject to a scholarship income tax.

Untaxed Scholarship Funds

The IRS is pretty generous when it comes to scholarships and taxes, making it possible to avoid the awards counting as taxable income by spending this type of financial aid money in the right way. When scholarship funds are used for required educational expenses, they are considered qualified scholarships and are generally tax-free.

In most cases, your student doesn’t have to pay taxes on college scholarships if the cash is spent on qualified educational expenses (based on the IRS definition). Qualifying educational expenses include:

• Tuition Expenses

• Fees (including mandatory student activity fees)
• Books
• Supplies and equipment required (as listed by the course or institution)

Essentially, if the expense is a requirement for enrolling in the college or a particular class, your student usually won’t owe taxes on the scholarship funds used to pay that cost. Only fees required for enrollment or attendance, as well as supplies and equipment required for coursework, are considered qualified expenses for tax-free scholarships.

It also doesn’t matter if your student pays the money to the college. For example, if your student opts to buy their books online instead of at a campus bookstore, that is still a qualifying educational expense.

It is important to note when it comes to scholarships and taxes, optional equipment, as well as optional books and supplies, might not be considered qualifying educational expenses. For instance, if your student buys a book from the campus bookstore that is not on the required list (even if it could be relevant to their education), or purchases optional equipment for convenience, those items might not meet the IRS’s definition, putting them in the non-qualified expenses category. Qualified educational expenses generally include fees, books, supplies, and equipment required by the course or institution.

Taxable Scholarship Funds

Scholarship money not used on qualifying higher education expenses is considered taxable gross income. This includes funds spent on other expenses, incidental expenses, related expenses, as well as any your student chooses to save for a rainy day.

Regardless of whether the money is used to pay the school or any other business or institution, these costs are not qualifying educational expenses in the eyes of the IRS:

• Room and Board
• Insurance
• Medical Costs (including student health fees)
• Transportation
• Utilities
• Equipment or Supplies Not Required for a Qualifying Course
• Incidental Expenses
• Other Living Expenses or Personal Expenses

Similarly, money spent on sports that are not part of credit-earning courses does not qualify. Unless the sport is part of an actual degree plan, any scholarship money spent on it is taxable. The same goes for hobbies, games, or social events. Payments received for services required, such as teaching or research, or for other services, are considered taxable income. Any payment that is compensation for services is also taxable.

Taxable Stipend Scholarships

While most scholarship awards used on qualifying educational expenses are not taxed, if your student’s scholarship includes a stipend, that money is usually considered income.

A stipend is money given in exchange for a service. For example, if your student receives a scholarship in exchange for assistant teaching a class, that money is income and therefore taxable.

This caveat also applies to scholarships given that require the promise of future services. Playing off that last example, if your student is a freshman, accepts the scholarship, and that scholarship is compensation for a commitment to assistant teach when they are a senior, that is a stipend and is taxable income.

Usually, stipends occur more for graduate student scholarships than undergraduate students. However, that doesn’t mean there aren’t undergrad scholarships out there with stipends, so it is important to be aware of this scenario when you are trying to understand scholarships and taxes.

Is There a Scholarship Tax Credit?

There isn’t technically a scholarship tax credit. However, if some of your student’s scholarship funds qualify as taxable income, they may be eligible for an education credit that can lower their tax burden.

Essentially, the IRS does not allow a student to use the credit on expenses paid with tax-free scholarships. Students cannot double dip by claiming both a tax credit and a tax-free scholarship for the same educational activities or expenses. But, if a scholarship becomes taxable income, your student can potentially use educational credits to offset the cost of any additional qualifying educational expenses that weren’t covered with tax-free scholarship money.

Usually, this scenario doesn’t occur. However, if your student happens to end up in this situation, they may get some tax relief.

How to File Taxes for Scholarships

If all of the funds are spent on qualifying educational expenses, your student is in luck. That scholarship is tax free, so your student doesn’t have to worry about reporting it on their taxes at all.

But, if some or all of the money is taxable, filing taxes on the scholarship is a must. Luckily, filing taxes for scholarships is pretty straightforward. In most cases, the awarding organization will provide your student with a W-2 (the same as they would get from an employer), and the taxable income amount will be listed in Box 1. That number in Box 1 then gets listed on Line 1a of IRS Form 1040 when your student files their taxes. The total amount and amounts received from scholarships, fellowships, and grants should be reported accurately to ensure compliance.

In rare cases where a W-2 isn’t provided, that doesn’t mean your student doesn’t have to report any taxable scholarship income. Instead, they need to calculate the amount of taxable income by subtracting qualifying expenses from the amounts received, put it on Line 8 of IRS Form 1040, and enter “SCH” on the dotted line next to Line 8. Students will also need a Schedule 1 form to accompany the figure entered on Line 8 of their Form 1040.

If your student struggles to figure out their scholarships and taxes because they aren’t certain if they spent money on qualifying educational expenses, their school answers at least part of that question. The college will issue a 1098-T, and that can serve as a guide. It’s important to use the correct forms and consult the IRS website for additional guidance and resources.

Is There a Special Tax Form for Scholarship Income?

No, there isn’t a tax form specifically for handling scholarship funds when students complete their tax return. There are various types of grants, including Pell Grants, need based grants, and other grants, each with their own reporting requirements. A grant may be reported differently depending on its type and use. Your student will only need to complete IRS Form 1040 to report the taxable scholarship income.

Do You Have to Make Estimated Tax Payments on Scholarship Funds?

If part or all of your student’s scholarship is taxable, they may need to make quarterly estimated tax payments based on that money qualifying as income. Since taxes are not automatically withheld from scholarships (like they are from traditional employer paychecks), they might need to make payments during the year to satisfy the IRS requirements, similar to how self-employed individuals have to manage their tax obligations.

Whether your student needs to pay estimated taxes on the scholarship awards depends on their unique situation. However, the IRS has a quick online interview that can help your student figure it out: Am I Required to Make Estimated Tax Payments?

Is It Worth Dealing with Scholarships and Taxes?

In nearly every case, dealing with scholarships and taxes is worth it. Even if a scholarship becomes taxable income, your student pays much less in taxes on the award than the full value of the scholarship. Additionally, it may help them avoid costly student loans, the cumulative interest on which will usually exceed the amount your student would pay in scholarship taxes incredibly quickly.

Ultimately, scholarships are a cost-effective option, even if your student has to pay taxes on the taxable portion. If you and your student want to learn more about where to find and how to land scholarships, attend our free college scholarship webinar! Head to https://thescholarshipsystem.com/webinar to sign up.

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