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.

 

Types of Financial Assistance

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.

  • Loans. Loans, including those students receive through federal programs, aren't taxable. Loans are a debt that must be repaid, usually with interest. They aren't considered income for tax purposes [source: Finaid].
  • Work-study Programs. Money received through work-study programs is money earned for services and is taxable. These programs, usually run through a college's financial-aid office, help students pay for their education. But because they are actually part-time jobs, students must report the income for federal tax purposes. There may be an exception if all students at a school or in a certain program are required to hold a part-time job to obtain a degree [source: Newaccountant].
  • Other employment. This isn't really financial aid, but some people think that Uncle Sam gives a tax break to struggling students. He does not. Any money earned -- including tips -- must be reported for federal income tax purposes, even if a student doesn't earn enough to have to pay taxes. For lucky students, it might prove worth filing a return to get a refund of all or most of the money an employer withheld for tax purposes [source: IRS].
  • Scholarships won as contest prizes. If a prize is called a scholarship but the winner can use the money for any purpose, but not necessarily to pay for education, then the prize money is fully taxable [source: IRS].

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

  • Scholarships. The Internal Revenue Service (IRS) defines a scholarship as "an amount paid for the benefit of a student at an educational institution to aid in the pursuit of studies." The IRS makes no distinction between scholarships for undergraduate or graduate studies [source: IRS].
  • Fellowships. In IRS terms, a "fellowship grant generally is an amount paid for the benefit of an individual to aid in the pursuit of study or research" [source: IRS]
  • Grants. The IRS considers grants, including the federal, need-based Pell Grants the same as scholarships. They fall under the same rules for taxability. [source: IRS]

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.

Payment For Services

Graduate teaching assistantships and research fellowships can be taxable.
Graduate teaching assistantships and research fellowships can be taxable.
Jack Hollingsworth/Getty Images

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.

Is financial aid taxable or not?

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.

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Sources

  • Dodson, Barry Z. Certified Public Accountant, Madison, N.C. Personal interview, Jan. 5, 2009.
  • FinAid. "The Smart Student Guide to Financial Aid." http://www.finaid.org/scholarships/taxability.phtml (Jan 3, 2010)
  • Gober, Jerald R. "Funds and Taxes for the College Student." New Accountant.http://www.newaccountantusa.com/newsFeat/is/is_fundsandtaxes.html (Jan. 8, 2010)
  • H&R Block. "Tax Tips & Calculators" Tax Tip 61: College Financial Aid. http://www.hrblock.com/taxes/tax_tips/tax_planning/offtocollege.html?ttiptitle=College%20Financial%20Aid (Jan. 8, 2010)
  • Internal Revenue Service. "Fulbright Grants." IRS.gov. http://www.irs.gov/businesses/small/international/article/0,,id=149708,00.html
  • Internal Revenue Service. Helpline for Individuals. Personal interview via telephone. Jan. 7, 2010.
  • Internal Revenue Service. "IRS Hotlines and Toll-Free Numbers." IRS.govhttp://www.irs.gov/businesses/small/article/0,,id=161104,00.html (Jan. 8, 2010)
  • Internal Revenue Service. Publication 970 (2008). "Tax Benefits for Education."http://www.irs.gov/publications/p970/ch01.html (Jan. 2, 2010)
  • Internal Revenue Service. "Taxable Income for Students." http://www.irs.gov/individuals/students/article/0,,id=96674,00.html (Jan. 2, 2010)
  • Scholarships.com. "Find Money for College."http://www.scholarships.com/scholarships-grants-fellowships-internships.aspx (Jan. 8, 2010)