Is financial aid taxable?

First, consider what type of aid you receive.

There are several basic types of financial assistance for students. Some are taxable, some aren't, and some are partially taxable under certain circumstances. The taxability of some sources of income for students is clear cut.

The taxability of other common types of financial aid is less clear:

So, payment for work or prize money that can be spent for anything is taxable. On the other hand, loans are tax-free. Scholarships, fellowships and grants, however, may be taxable.

Keep reading to sort out the fine print.

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:

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.

The first couple of requirements for scholarships, fellowships or grants to be tax-free are easy: First and foremost, the student must be working toward a degree. In addition, the student must be studying at an educational institution that the IRS considers "qualified." The school must be an accredited one that can either grant recognized bachelor's degrees or higher, or prepare students for a job in a "recognized occupation." The IRS specifies that a school must have "regular" faculty and curriculum and must "normally" have students who physically attend classes.

If you pass those tests, all or part of your financial aid may be tax-free. The details of the next requirement can be trickier. A scholarship, fellowship or grant that otherwise meets the rules should be tax free as long as the money is used for what the IRS terms "qualified educational expenses."

Qualified expenses include any required tuition and fees, as well as other expenses like books, supplies and equipment that are required of all students in a certain course.

Essentially, any scholarship, fellowship or grant money used for anything else is taxable. That includes money used for travel, room and board, research and clerical help. Publication 970 and the IRS helpline offer the same advice: Those are the rules, and there don't seem to be exceptions. If part of an athlete's full scholarship pays for room and board, for example, that part is taxable. If part of a Fulbright grant goes to pay for travel, room or board, that part is taxable. If a student on a Fulbright grant isn't working toward a degree, the entire scholarship amount is taxable [source: Fulbright].

The burden of keeping track of what part of a scholarship, fellowship or grant is taxable falls on the student. Many grant programs, such as those run by individual states, give money for tuition or other qualified expenses only, so that none of the money will be taxable.

Schools are required to issue W-2 forms for paid assistantships and other campus jobs, but they are not required to report scholarship money [source: Newaccountant]. Many college financial-aid offices advise students to keep receipts documenting the money they spend on tuition, fees and other qualified educational expenses. They should deduct that amount from the amount of their scholarship, fellowship or grant, and report any extra money as taxable income.

The most important thing to remember is to leave nothing to chance. Questions about whether your financial aid is taxable? Ask your tax preparer or accountant, or go directly to the IRS.