Learning that your child has received a merit or athletic scholarship, fellowship, or grant is usually good news to receive. However, while the funding that an educational institution awards a student is typically tax-free, there are certain situations that can cause the scholarship, fellowship, or grant monies to be taxable. It’s important to understand what situations will trigger a taxable event for these educational gifts in order to set aside taxes if the award falls into a taxable category.
What Qualifies as a Non-Taxable Award
Because scholarships, fellowships, and educational grants are not generally considered as income, the IRS mostly treats these awards as non-taxable for the K-12, college, graduate school, and accredited vocational school students who receive them. In order to keep the awards completely tax-free, the IRS requires these conditions, outlined in IRS Publication 970, to be met:
- The award recipient must be enrolled as a degree candidate at an eligible educational institution which has a regular faculty, curriculum, and student body;
- The money is used only for qualified expenses such as tuition, books, and course or degree-related expenses like class supplies; and
- The money granted is not equivalent to teaching wages or other work-study type of payments.
Students who meet these three requirements can expect to avoid paying taxes on their scholarship, fellowship, or grant as long as the full amount of the award is exclusively used to cover the costs of the above-mentioned items.
Some other payment programs that afford aid to students – such as those retained through the GI Bill, the National Health Service Corps Scholarship Program, the Armed Forces Health Professions Scholarship, and the Financial Assistance Program – as well as student loans, are also excluded from taxation, since they are not considered as taxable income and, in the case of loans, will need to be repaid at a future date.
What Triggers a Taxable Situation
Whether the scholarship, fellowship, or grant makes a direct payment to the student or is issued to reduce the tuition amount is not a factor in what can trigger a taxable situation. How the money is being used is the crucial factor. Taxes will be owed on any portion of the awarded monies that go towards education-related expenses outside of the allowable scope such as room, board, other living expenses, and travel. However, any portion of the monies that are used for allowable costs will still avoid taxation.
While there are a few exceptions, award payments are also taxable if they are connected to services the student is obligated to perform as a condition of receiving the award, regardless of whether those services are required of all students in the program (both scholarship recipients and those who are paying all costs out-of-pocket). Therefore, a stipend your child receives for required teaching or research-related services is viewed as income and is therefore taxable, even if the student instead chooses to use the money for tuition or related expenses that are otherwise considered tax-free. For these types of taxable scholarships, fellowships, and grants, the educational institution will issue a W-2 to the student for the tax return they’ll be required to file.
Finally, scholarships, fellowships, and grants that are given to students who are not attending an eligible school or who are not participating in a degree program will be taxable.
When and How to Submit a Tax Return
If your child has no additional income, and what they were awarded through their scholarship, fellowship, or grant is tax-free, they are likely not required to complete and submit a tax return. Any part of an award that has been allocated by the donating institution as payment for services is treated as income and requires a tax return to be completed using the W-2 provided by the issuing institution showing the amount of wages and taxes withheld. Should you fail to receive a W-2, it’s still your obligation to report that taxable portion of the scholarship, fellowship, or grant as income on a tax return.
You will also want to look into how the receipt of a scholarship, fellowship, or grant may impact your eligibility for other higher education tax credits to fully understand the tax benefits you or your student will ultimately receive for their education.
If you have questions on whether your child’s educational award will be tax-free or will trigger a tax consequence, contact your Untracht Early advisor.