Scholarships and Grants Tax Implications

Introduction

Student financial assistance through scholarships and grants can substantially reduce educational costs, allowing students to pursue their academic aspirations without accumulating significant debt. While financial aid usually offers benefits, many students and families are unsure about whether these funds are subject to taxation. The answer depends on how the funds are used and the specific terms of each scholarship or grant. Understanding these tax implications is essential to avoid unexpected tax bills and maximize potential savings.

Are Scholarships and Grants Taxable?

Scholarships may feel like free money, but the IRS has specific rules regarding which funds are tax-free and which are taxable. Understanding these distinctions is crucial for students and families receiving financial aid.

When Scholarships Are Tax-Free

Scholarships generally remain tax-free when used for qualified education expenses and when the student is pursuing a recognized degree at an eligible educational institution. Qualified expenses include tuition, required fees, textbooks, and necessary supplies or equipment. For example, a student receiving a $12,000 scholarship and applying the entire amount toward tuition and required textbooks would not owe taxes on those funds.

Tax-free status guarantees that students can utilize scholarships for their intended use without concern about raising their tax burden. This also emphasizes the significance of precisely directing scholarship funds exclusively toward eligible expenses.

When Scholarships Become Taxable

Scholarships become taxable when used for non-qualified expenses, or when awarded in exchange for services. Living expenses such as room and board, travel, and personal items are considered non-qualified. Additionally, graduate students receiving stipends for research or teaching are taxed on those amounts as compensation. Scholarships for non-degree programs, including short-term workshops or noncredit courses, are also taxable.

What Counts as Qualified Education Expenses?

To determine whether a scholarship or grant is taxable, it is essential to understand which expenses qualify for tax-free treatment. The IRS considers the following as qualified education expenses.

Tuition and Fees

Tuition and mandatory fees paid to a qualifying educational institution are the main eligible expenses. These expenses must be essential for enrollment or attendance at the institution.

Books, Supplies, and Equipment

When a course requires specific books, supplies, or equipment, and these are purchased using scholarship funds, the expense remains tax-free. However, general-purpose items, such as a laptop, are only considered eligible if the school explicitly requires them.

Non-Qualified Expenses

Certain education-related expenses do not qualify for tax-free scholarship treatment. Housing and meals, transportation, health insurance, and optional equipment or fees are not considered eligible expenses. When a scholarship is used for these costs, the amount spent may be subject to taxation.

How to Report Taxable Scholarship or Grant Income

When any portion of a scholarship or grant is considered taxable, the recipient must report it on their tax return. Students receiving taxable scholarship income may need to file a tax return, depending on their total income and filing status.

Reporting on Form 1040

Taxable scholarship income must be reported on IRS Form 1040, but updated guidance has modified where and how it is entered.

Under current IRS rules, taxable scholarship and fellowship amounts are included in the total wages reported on Line 1a of Form 1040. If the scholarship was not reported on a Form W-2, the student must also enter the taxable amount on Line 8 and attach Schedule 1 (Additional Income and Adjustments to Income). This ensures the IRS receives proper documentation, especially for stipends or scholarship amounts connected to services such as teaching or research.

Understanding Form 1098-T

Colleges and universities issue Form 1098-T to students who have made qualified tuition and related payments. This form helps determine how much of a scholarship is applied to tuition and how much may be taxable. However, it does not explicitly state whether a scholarship is taxable. Students must carefully review their expenses and financial aid awards.

Example of Reporting

Can Scholarships and Grants Affect Other Tax Benefits?

Scholarships and grants can impact a student's eligibility for education-related tax credits. The American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC) allow taxpayers to reduce their tax liability based on qualified education expenses. However, these credits can only be claimed for expenses that are not covered by scholarships or grants.

Effect on the American Opportunity Tax Credit

The AOTC provides a tax credit of up to $2,500 per eligible student for qualified tuition, fees, and course materials. If a scholarship covers all of a student's tuition and fees, they may not have enough out-of-pocket expenses to claim the full credit. In some cases, students may strategically allocate scholarships to non-tuition expenses to maximize their tax credit eligibility.

Impact on the Lifetime Learning Credit

The LLC allows a credit of up to $2,000 per tax return for postsecondary education expenses. Like the AOTC, the credit is only available for expenses that are not reimbursed by scholarships. If a student receives a full-tuition scholarship, they may not be able to claim the LLC.

Example of Tax Credit Interaction

The One Big Beautiful Bill Act and New Federal Scholarship Programs

Recent federal legislation has created new opportunities for tax-free scholarships, especially for K–12 education.

Overview of the Act

The 2025 One Big Beautiful Bill Act (OBBBA) introduces a federal tax credit scholarship program effective January 1, 2027. Families can receive tax-free scholarships through Scholarship Granting Organizations (SGOs), and donors contributing to SGOs may claim federal tax credits. This program marks a significant expansion of tax-free educational funding outside traditional higher education.

Scholarship Granting Organizations (SGOs)

SGOs must operate as 501(c)(3) nonprofits in states that opt into the program. They are required to serve a minimum number of students across multiple schools, allocate at least 90% of revenue to scholarships, and ensure recipients meet income eligibility guidelines. Contributions cannot be earmarked for specific students, promoting equitable distribution of funds.

Donor Tax Credit

Donors may claim a nonrefundable federal tax credit of up to $1,700 for contributions to SGOs, reduced by any state-level credits. Unused credits can be carried forward up to five years. This provides a powerful incentive for donors to support educational opportunities while reducing their own tax liability.

Tax-Free Receipt of SGO Scholarships

Scholarships awarded through SGOs are fully tax-free for recipients, even when used for expenses that would normally be non-qualified under IRS rules. For example, a family receiving a $5,000 SGO scholarship for private school tuition, books, and enrichment programs after January 1, 2027, will not include any portion in taxable income.

State Participation

Federal benefits apply solely in participating states. Families and donors in non-participating states cannot claim the federal credit, emphasizing the significance of understanding local program availability.

Scholarships and FAFSA Reporting

Scholarships also impact financial aid calculations and reporting obligations.

Reporting Requirements

When completing the Free Application for Federal Student Aid (FAFSA), students must report scholarships and grants considered taxable by the IRS. Even if a scholarship is tax-free under IRS rules, it may need to be included if it affects the expected family contribution or other need-based aid. Accurate reporting ensures correct financial aid assessment and timely funding.

International Students and Nonresident Considerations

Nonresident aliens and international students must navigate unique scholarship tax rules.

Taxable Amounts for International Students

Scholarships and fellowships for nonresident aliens may be subject to withholding and reported on Form 1042-S. Portions tied to services, like teaching or research, are considered taxable wages. Consulting a tax professional familiar with nonresident tax rules is essential to ensure compliance and avoid unexpected liabilities.

Practical Strategies to Minimize Tax Liability

Proper planning can help students reduce taxable scholarship income and maximize benefits.

Track Expenses Carefully

Students should maintain detailed records of how scholarship funds are spent, distinguishing between qualified and non-qualified expenses. This ensures accurate reporting and prevents errors on tax returns.

Coordinate With Tax Credits

Strategically allocating scholarships can maximize education tax credits like the AOTC or LLC, minimizing total tax liability. Planning how scholarships interact with credits is a key strategy for tax optimization.

Leverage New Federal Programs

Families can benefit from federal SGO programs by understanding eligibility requirements, state participation, and donor credits. Properly leveraging these programs maximizes tax-free benefits and educational impact.

Frequently Asked Questions

Understanding scholarship tax implications can be complex. Here are answers to common questions about scholarships and grants.

Tax Help for College Students

Scholarships provide essential financial support, but understanding their tax implications is critical. Funds used for tuition, required fees, textbooks, and course supplies are typically tax-free, while money spent on living expenses or received for services is taxable. Federal programs like SGOs under the One Big Beautiful Bill Act expand tax-free opportunities and create donor tax credits.

Monitoring expenses, aligning scholarship use with education credits, and seeking tax professional guidance enables families to optimize financial aid benefits and reduce tax liability, ensuring that scholarships serve their intended purpose without generating unexpected financial burdens.