Scholarships (and fellowships) are generally tax-free. However, the most important criteria to make a scholarship tax free is that the award must be used for tuition and related expenses (and not for room and board) and that it must not be compensation for services (for example working at the school). To be considered a scholarship, an amount does not need to be formally designated as such.
What does the IRS consider a Scholarship?
Generally, a scholarship is an amount paid for the benefit of a student, to aid the student in the pursuit of study at an educational institution. A scholarship or fellowship payment may be in the form of a reduction in the amount owed by the payee to an educational organization for tuition, room and board, or other fees (tuition waiver). ‘Non-qualified’ scholarships/fellowships may include payments for room/housing, board/meals, medical, stipends, thesis support, travel, cash, as well as non-required fees, books, supplies, and equipment.
This is regardless of the education level and will apply for elementary or high school students, for college or graduate students, and for students in accredited vocational schools. It does not matter whether the scholarship takes the form of a direct payment to the individual or a tuition reduction that occurs on the tuition statement in order for the scholarship to be tax free.
The following criteria below explain the tax treatment of scholarships and fellowships:
- Tuition and related expenses. A scholarship is tax-free only to the extent it is used to pay for tuition and fees required to attend the school or fees, books, supplies, and equipment required of all students in a particular course. The money must be used on items that are necessary to obtain the education. For example, other expenses that don’t qualify include the cost of room and board, travel, research, and clerical help.
- To the extent a scholarship award isn’t used for qualifying items, the scholarship is taxable. The recipient is responsible for establishing how much of the award was used for qualified tuition and related expenses so as to be tax-free. Parents or students should maintain records (e.g., copies of bills, receipts, cancelled checks) that reflect the use of the scholarship money.
- Scholarship award can’t be payment for services. Again, this is the most important criteria. A scholarship isn’t tax-free if the payments are linked to services that the student performs as a condition for receiving the award, even if those services are required of all degree candidates. A stipend received for being a teaching assistant would not be considered tax free.
- Must Keep Accurate Returns and records. If the scholarship is tax-free and your child has no other income, the award doesn’t have to be reported on a return. However, any portion of the award that is taxable as payment for services is treated as wages, and the payor should withhold accordingly. Estimated tax payments may have to be made if the payor doesn’t withhold enough tax. Most likely a W-2 will be received from the educational institution if the scholarship is for services and subject to income tax.
There are several issues for parents of children receiving scholarships:
- The dependency exemption that a parent can claim for their children will not be affected by a scholarship. To claim an individual as your dependent, you must meet a support test. Although education is a support item, a special rule provides that educational costs covered by a scholarship (or fellowship) for a dependent who is a child of the taxpayer (but not for other dependents) are not included in the calculation of total support.
- Any taxable scholarship amounts should increase your child’s standard deduction. As noted above, to the extent scholarship funds are spent on room, board, or other nonqualifying expenses, the award is taxable. However, it is treated as “earned income.” This means if the student is claimed as a dependent by his parent and takes the standard deduction, he or she may qualify for a higher standard deduction. The standard deduction allowed to dependents is the greater of: (a) $1,000 (for 2014) or (b) $350 (for 2014) plus the dependent’s earned income. But the standard deduction can’t be more than the regular standard deduction ($6,200 for single taxpayers in 2014). Even if the scholarship is taxable, the standard deduction may eliminate any tax liability.
- The tax-free scholarship may limit other higher education tax benefits to which you or your child may be entitled. Neither you nor your child may claim a credit, deduction, or exclusion for expenses paid with tax-free scholarship funds.
Other Education Related Tax Tips
If the child of a taxpayer receives a tax-free scholarship and his or her higher education expenses also qualify for any of the following credits, deductions, and exclusions, the expenses taken into account in computing any of these other benefits must first be reduced by the tax-free amounts used to pay the expenses:
- American Opportunity tax credit and Lifetime Learning credit. Deduction for higher education expenses. Deduction for interest on student loans. Coverdell ESA distribution exclusion.
- Qualified tuition (529) plan distribution exclusion. Savings bond interest exclusion.