Is financial aid taxable?

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.