Scholarships may count as income depending on how funds are received and spent, meaning that they could be taxable.
Usually, scholarships don’t have to be repaid like student loans, though they may carry requirements for continued funding, such as a minimum GPA or competing on a collegiate sports team.
According to Sallie Mae’s How America Pays For College 2020 report, scholarships and grants covered 25% of education costs on average.
But does this free money for college come with any other caveats? It depends.
If you or your student received scholarship funding, it can be helpful to know ahead if it will contribute to your tax liability. Here’s what you need to know about identifying taxable scholarships and handling filing requirements.
Scholarships That Are Tax-Free
For many students, the scholarships they receive are tax-free. But in some cases, all or a portion of a student’s funding may be taxable.
Students can be exempt from paying taxes on their scholarships if they satisfy certain criteria. For one, they must be enrolled at an accredited college, university, or educational institution that maintains regular attendance.
Additionally, scholarship funds must be used to pay for qualified education expenses—a determination made by the IRS. Under this definition, qualified education expenses include the following:
• Mandatory fees (e.g., athletic and tech fees)
• Equipment and supplies (e.g., lab equipment)
When it comes to textbooks, equipment, and supplies, anything that is required by your school to complete coursework would be free from taxes. If you use the funding towards an extra-curricular activity, such as a club or intramural sport, they are taxable.
If the scholarship is used for a certificate or non-degree program, the entire amount is taxable whether or not funds are used for qualified education expenses.
It’s important to note that any scholarship funds leftover after paying for qualified education expenses would not be tax-exempt.
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Scholarships Considered Taxable Income
How are scholarships taxable? According to the IRS, scholarships used for expenses outside the scope of qualified education expenses must be reported in gross income—making them taxable.
Scholarship funds used for the following costs are considered taxable by the IRS:
• Room and board
• Medical expenses
• Optional equipment (e.g., new computer)
But are scholarships taxable income in any other situations?
Scholarships that are awarded in exchange for services like teaching or research, often known as fellowships, are classified as taxable compensation in most cases. Students would have to pay taxes even if their fellowship money is used to pay for tuition and other qualified education expenses.
However, there are a few exceptions when education-related payments could be tax-exempt. Specifically, students do not have to pay taxes on funds received for required services through the following scholarship programs:
• National Health Service Corps Scholarship Program
• Armed Forces Health Professions Scholarship and Financial Assistance Program
• Student work-learning-service programs operated by a work college
Other forms of financial aid could be considered taxable income as well.
Earnings through the Federal Work-Study program are subject to federal and state payroll taxes. If you stay below 20 hours a week while enrolled full-time, you won’t have to pay FICA (taxes for Medicare and Social Security) taxes.
Even Pell Grants—a federal aid program for students with significant financial need—are taxable if they’re not used for qualified education expenses.
Making it Legal: Reporting Taxable Awards
If a college scholarship is considered taxable, the student would need to report the scholarship (or portion of the scholarship) on their tax return.
Some students may receive a W-2 form from the scholarship provider outlining the taxable amount. Otherwise, they may need to calculate and enter the amount on their own tax return.
There are three IRS forms to report taxable scholarships. Choose the following form that best fits your personal situation.
• Individual Income Tax Return: Form 1040
• Tax Return for Seniors: Form 1040-SR
• U.S. Nonresident Alien Income Tax Return: Form 1040-NR
Students filing either Form 1040 or Form 1040-SR can add the taxable portion of their scholarship to the total amount on the “wages, salaries, tips” line. If this was not recorded on your W-2, IRS instructions say to enter “SCH” with the taxable amount in the space to the left of the “wages, salaries, tips” line.
International students using Form 1040-NR simply report the taxable amount on the scholarship and fellowship grants line.
While students may be enjoying their newfound freedom at school, when it comes to taxes, they may need some assistance. This is an opportune time for parents of college students to offer guidance and support as needed. If you have outstanding questions about if any portion of your scholarships are tax-deductible, consider consulting with a tax professional for personalized guidance.
How Education Tax Credits Fit in
Students and their family members may be eligible to claim the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Credit (LLC) if they paid for college and related costs in the past year. Take note that you can’t use both tax credits for the same student in the same year.
To claim either tax credit, you’ll need Form 1098-T from your college. This form shows any reportable transaction for an enrolled student.
To qualify for the AOTC or LLC, you could have paid educational expenses out of pocket or with student loans. Expenses that were paid for by tax-free scholarships are not eligible for a tax credit.
The AOTC and LLC differ in scope and eligibility, so it’s helpful to compare both to see which may apply and provide a greater tax return.
American Opportunity Tax Credit (AOTC)
The AOTC can be used for qualified education expenses—tuition, fees, textbooks, and necessary supplies—for a student’s first four years of college.
The maximum credit currently stands at $2,500 a year for eligible students. This is calculated as 100% of the first $2,000 in qualified education expenses paid for an eligible student plus 25% of the next $2,000 in qualified education expenses.
If the AOTC reduces your taxes to zero, it’s possible to have 40% of the remaining credit (up to $1,000) refunded.
Eligibility for the AOTC is based on the tax filer’s modified adjusted gross income (MAGI). If you’re filing separately, your MAGI must be $80,000 or less to qualify for the full AOTC credit. The threshold is $160,000 for married filing jointly.
It’s possible to receive a reduced AOTC amount if filing separately with MAGI between $80,000 and $90,000 or $160,000 and $180,000 for married filing jointly.
The Lifetime Learning Credit (LLC)
The LLC can apply to a broader range of expenses than the AOTC. It can be used to claim up to $2,000 for tuition and related educational expenses for undergraduate, graduate, or professional degree courses. Costs of non-degree programs that improve job skills are also eligible for the LLC.
This credit does not have a limit on the number of years it can be claimed on your tax return. However, the LLC has stricter income requirements.
For Tax Year 2020, your MAGI must be below $69,000 (or $138,000 if filing jointly) to claim the LLC. Anyone with a MAGI between $59,000 and $69,000 (or $118,000 and $138,000 filing jointly) would only be eligible for a gradually reduced credit.
Don’t Forget Deductions
If you’re paying interest on a student loan, you may be eligible to deduct up to $2,500 with the student loan interest deduction. To be eligible, interest payments must be legally obligated and your filing status can’t be married filing separately.
There are also income requirements, which can vary annually, to factor in for the deduction calculation. For the tax year 2020, the filer’s MAGI must be less than $70,000 (or $140,000 if filing jointly) to be eligible for the full $2,500 deduction.
If your MAGI is between $70,000 and $85,000 (or $140,000 and $170,000 if filing jointly), you could qualify for a reduced deduction.
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Saving for your child’s college tuition can be challenging.
Scholarships, grants, and fellowships are helpful ways to make college more affordable. But in many cases, students and families are still left with some education costs to cover.
Parents have some options at their disposal to help pay for their child’s education. If you haven’t saved enough, you may consider using retirement funds to pay for tuition and room and board, though this could result in penalties or fees.
Students can apply for federal student aid by filling out the Free Application for Federal Student Aid (FAFSA®), annually. This allows them to apply for scholarships, grants, work-study, and federal student loans.
If those funding sources aren’t enough, another avenue to consider may be private student loans. Private student loans don’t always offer the benefits that are afforded to federal student loans, such as deferment or forbearance.
Private lenders may not offer the same benefits as federal loans, including income-driven repayment and loan forbearance, so they are generally considered only after all other options have been reviewed. However, borrowers with strong credit may qualify for a competitive interest rate.
If you’re considering a private student loan, SoFi can help. With SoFi, borrowers can choose from four repayment plans and there are no hidden fees.
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