Is financial aid taxable?

Your college financial aid isn't exactly free money -- you may have to give a portion of it to Uncle Sam.
Your college financial aid isn't exactly free money -- you may have to give a portion of it to Uncle Sam.
Vanessa Gavalya/Getty Images

Sweet! You've been given -- or won -- some much-needed money to help you pay for your higher education. Now you can afford to pay for tuition, books and other necessities without facing such a steep mountain of debt after you graduate.

Unfortunately for you, however, that good news came last year. Now it's a new year. And with each new year comes federal income-tax season. And with income-tax season comes questions.

Is that money for college really just something you've been granted or earned by merit, something you don't have to pay back, and also don't have to list as taxable income? Could it all be that easy? Or is that too good to be true? Are there some strings attached somewhere?

The answers are yes, no and maybe. Scholarships, fellowships and grants may be taxable under certain circumstances, but they aren't in other cases. Often, parts of scholarships, fellowships or grants are tax-free, but other parts might be considered taxable income.

Think of it this way: Uncle Sam uses the tax code to promote certain things that lawmakers consider valuable to our society. That's why there are tax breaks for home ownership (mortgage interest) and for families (deductions for dependent children). Uncle Sam considers getting a higher education a virtue as well, so he's willing to give students a break from paying taxes on much of the money they get to help them go to college or graduate school.

But Uncle Sam and the lawmakers also think it's a virtue for people to pay their fair share of taxes to help keep the country functioning. So they have placed some limits on just what's deductible.

Many people believe that scholarships, fellowships and grants are always just free money for legitimate students and institutions of higher learning. Many people are wrong. It's never a good idea to fail to list taxable income. Anyone who receives financial help for higher education would be wise to understand the ins and outs of applicable tax rules.

Confused? Read on for some tips on how to figure things out.