Are scholarships taxable? You may be surprised that not all scholarships to pay for college are considered tax deductible.
Yes, this “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 taxed for the recipient. If a donor contributes money to a homeless shelter or soup kitchen, the services are tax deductible to the beneficiary.
But if the donor provides a grant or scholarship that covers housing and meal plan expenses for the student, the grant is considered taxable income to the recipient. This is despite the fact that more than half of college students experience it Food or housing insecurity According to a national survey in 2019, before the pandemic.
The tax on scholarships prevents students from taking full advantage of their scholarships. Learn about the rules regarding tax-deductible and taxable scholarships.
Growth in taxable scholarships
The number and amount of taxable scholarships reported on federal income tax returns have increased significantly in recent years. This table is based on the estimates presented in IRS income statistics In addition to data received from the IRS through a Freedom of Information Act request (2022 is the latest year for which this information is available).
IRS taxable scholarship data. Source: Mark Kantrowitz
What are tax-deductible scholarships?
The Internal Revenue Code of 1986, at 26 USC 117, establishes several requirements for the tax treatment of scholarships. Below we break down these rules to show the differences between tax-deductible and taxable scholarships.
Tuition, fees, books, and supplies
Generally, for a scholarship to be a tax levy, it must be used to pay tuition and required fees, books, supplies, or equipment. Only the portion of the scholarship that is used to pay these eligible tuition fees and related expenses is tax deductible.
If an educational institution offers a tuition waiver or reduction in tuition to its faculty and staff, it is tax-exempt if that benefit is provided on substantially the same basis to all members of the employee group. The employee group must not discriminate in favor of officers, owners, and high-paid employees.
The student must have a degree or certificate from an accredited educational institution. Otherwise, the entire grant amount is subject to tax.
Living expenses
The portion of the grant used to pay for room and board, transportation, disability-related expenses, dependent care costs, and other living expenses is taxable. This includes amounts for living expenses, such as a living stipend, even if the recipient uses the scholarship to pay eligible tuition and related expenses.
Service fees
If the grant is considered a fee for services, such as employee benefits, the entire grant amount is taxable. A grant is considered a fee for services if the services are required as a condition of the grant. However, there are exceptions for graduate teaching and research assistantships and some federal health professions scholarships.
The above rules apply to all types of scholarships and grants, including private scholarships, athletic scholarships, Pell grants, and Fulbright grants. However, veterans’ education benefits are tax deductible.
Emergency relief
Emergency financial aid grants provided under the CARES Act in connection with the COVID-19 pandemic are tax deductible, even if used to pay for living expenses. This provision is limited to eligible 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 scholarships, grants, fellowships, and tuition waivers that are taxable during the tax year are required to report the taxable portion on their federal income tax returns.
The taxable grant amount must be reported on Line 1 of IRS Form 1040. If the taxable grant amount is not reported on IRS Form W-2, write “SCH” and the taxable amount on the dotted line next to Line 1.
Related to: The best free tax software
Alternative solutions to the tax treatment of scholarships
Scholarship providers have begun to explore ways to award scholarships that reduce the tax impact. This includes awarding the scholarship as a contribution to the student’s 529 college savings plan or through student loan forgiveness.
An added advantage is that these alternatives can eliminate or reduce scholarship displacement. Scholarship offset occurs when a college reduces its scholarship amount after a student receives a need-based scholarship. If a scholarship is used in calculating the Student Aid Index (SAI), no scholarship offset can occur.
Typically, the taxable portion of the scholarship is subtracted from gross income on the Free Application for Federal Student Aid (FAFSA). Therefore, receiving a scholarship does not affect the EFC. However, if a scholarship is awarded as a contribution to a student’s 529 college savings plan, which is reported as an asset on the FAFSA, it has a small impact on the SAI (increased by up to 5.64% of the scholarship amount).
Likewise, if a scholarship is awarded through student loan forgiveness after a student graduates, it does not affect the student’s eligibility for need-based financial aid.
