Tax time is stressful for everyone. Finding the right forms, checking for mistakes and organizing your receipts can drive anyone mad. The US tax code is one of the most complex in the world and deciphering its rules and regulations are difficult for most people.
One of the toughest parts to figure out for people is how the IRS looks at college scholarships and grants. Are they income? Are they exempt? How should your child report the income? What kind of forms do they need? Where can they find the answers?
Fortunately, there are specific rules for scholarships and taxes that even the most confused parent can follow. Read below for our explanation on how your child’s scholarships will be taxed.
Are Scholarships Taxed?
The good news: scholarships are almost always not considered taxable unlike other forms of income. However, that stipulation depends on what you use the scholarship for. It’s not about whether you got the scholarship from a certain institution, it’s about what you spend it on. Grants and fellowship awards can also count for this tax-exemption.
The government allows students to spend scholarships on the following without taxing the money:
- Tuition and fees
- Cost of books, supplies, and equipment required by the college
Room and board do not count as eligible expenses. So if you are counting on that $5,000 scholarship to pay for a swanky loft, make sure to save part of that money for taxes. Meals, furniture, and apartment supplies are also not tax exempt. However Pell Grants are tax-exempt if the receiver uses them for the above reasons.
“If your award covered both tuition and room and board, the amount you use for tuition is tax-free,” says Marguerita Cheng, Certified Financial Planner, advisor at Blue Ocean Global Wealth and parent of a recent college student. “Many people are not aware of this. However, the amount you use for room and board is taxable. Remember, if you need to make this adjustment, you may have to adjust other parts of your return as well.”
For example, if you are filing a deduction for educational expenses, you must reduce the amount of your deduction by the tax-free amount of the award.
However, students must also fulfill the following requirements in order to follow the IRS guidelines, “You’re a candidate for a degree at an educational institution that maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where it carries on its educational activities.”
Cheng said if you don’t meet all of the guidelines set by the IRS, you have to report the scholarship on your taxes as income.
“The award is tax-free only as long as you use it for the purposes outlined above,” Cheng said. “In other words, you can’t use your scholarship money to go to Cancun for Spring Break.”
Students and parents should remember that they’re usually free to spend scholarship money on whatever they want, unless it’s specifically designed to go toward tuition. If you receive more money than you need to pay for the semester, feel free to go to Australia. Just remember that you’ll owe taxes on that amount. Students should save about 20-30% of anything they receive in case they’ll owe taxes on it.
When filing your taxes, scholarships will be included in the portion marked, “Wages, salaries, tips.” Only input the amount that is taxable – you don’t have to include any money that you used for qualified expenses.
Another important distinction to keep in mind is that scholarships are a separate category from loans and work-study. Work-study counts solely as income, even if you used that money to pay for tuition. Students should keep track of any expenses they have related to work-study, as they might be able to deduct those on their taxes. This is another reason why scholarships and grants are preferable to work-study.
Student loans are not treated as income in any scenario. Plus, when students graduate, they’re able to deduct interest from student loan payments on their taxes.
Scholarships are confusing, so talk to your advisor, office of financial aid, or accountant if you have any questions. They’ll be able to help you figure out if you’re eligible, how to prove you used the money for outlined reasons and how to minimize your tax obligation.
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