The Internal Revenue Service (IRS) has rules about what "payment for services" actually means. It also has rules about whether scholarships, fellowships and grants -- or parts of them -- are taxable. The best source of information is the horse's mouth: the IRS. Publication 970, "Tax Benefits for Education," is the main document outlining these rules. Employees at the IRS helpline for individuals (800-829-1040, 7 a.m. to 10 p.m., Monday through Friday) will explain the information that applies to you [source: Internal Revenue Service Hotline]. As publication 970 spells out, money earned in work-study programs is taxable.
Tax liability in some other situations is a little murkier. Graduate schools sometimes call money paid to a student for teaching or research a fellowship. Fellowships generally are treated as scholarships and are not taxed, at least in part. But any part of a fellowship, scholarship or grant that is payment for services -- teaching, research or anything else -- is taxable, even if everyone pursuing the same degree must perform the same service [source: Internal Revenue Service Publication 970].
And it's not just payment for services during the tax year that might be taxable. Payment for required future services is also taxable. The example Publication 970 uses is of a medical student who receives a scholarship with a requirement to work in a certain area or capacity later. There will be a hefty penalty if the student doesn't fulfill the requirement. The scholarship is considered payment for future services, and it's taxable for the year the student receives it.
There are two major exceptions to the payment-for-services rule: students in the National Health Service Corps Scholarship Program and in the Armed Forces Health Professions Scholarship and Financial Assistance Program.
Another exception is possible if a graduate student receives a reduction in tuition rather than payment for teaching or research. Colleges and universities give students reduced or free tuition at that school or at another school, and that reduction in tuition may be tax-free under the right circumstances. For undergraduates, tuition reduction is tax-free if it's granted because:
- The student works or retired from the school.
- The student is the widow or widower of someone who worked at or retired from the school.
- The student is a dependent child of someone who would be eligible.
For graduate students, the rules are different and can provide a way for a graduate student to get a tax-free financial break for teaching or research. Graduate students at eligible schools don't have to pay taxes on tuition reductions if they teach or do research there.