We’ve discussed different tax benefits for education in the past, but this is the first time we’re covering the taxation of scholarship monies. Many students incorrectly assume that all scholarships are tax-free; however, that isn’t always the case. Preparing for and understanding the characteristics of the scholarship ahead of time can help avoid a surprise at tax time.
As a general rule, a scholarship is tax-free only to the extent that the amount received does not exceed “qualified expenses.” The term “qualified expenses” is frequently used for a variety of education-related tax rules, so it’s important to be aware that qualified expenses are defined differently for each specific educational tax benefit. In the case of scholarships, qualified expenses include tuition, fees, and expenses that are required by specific courses, such as lab fees, books, supplies, and equipment. It’s also important to note which expenses do not qualify, such as room and board, research, travel, and equipment that isn’t specifically listed as a requirement for enrollment. If a scholarship, or part of a scholarship, is earmarked specifically for any of these non-qualified expenses, that amount will not be considered tax-free, even if there are other qualified expenses that are paid out-of-pocket. The rules can get tricky, so it helps to look at an example.
Olivia receives a scholarship for $20,000. Her tuition (for which she receives a 1099-T) is $15,000. Her expense for books is $1,000 and she purchased a new computer for $1,000. Her room and board on campus is another $20,000. In this case, Olivia has to include $4,000 of her scholarship as income on her 1040 even though she had $42,000 in total school expenses and a $20,000 scholarship. This is because the school doesn’t require the computer, so the only qualified expenses she has are the $15,000 of tuition and the $1,000 spent on books. The cost of room and board, even if it’s on campus with a meal plan, does not count either.
There are some other rules as well. In order for a scholarship to be tax-free, the student must be enrolled as a degree-seeking candidate at an eligible institution. You also cannot “double-dip” by combining other education tax benefits with expenses. For example, if you have $20,000 in qualified expenses, you can only attribute those dollars to one tax benefit. You could attribute $4,000 to the American Opportunity Tax Credit and the rest to scholarship, and any excess to a 529 plan distribution, but you can’t attribute the same dollars to all three benefits. The good news is that since each tax benefit has its own definition of qualified expenses, you may be able to claim a portion of the credit for other expenses, such as room and board in the case of a 529 plan withdrawal for a full-time student.
The overlapping of these benefits can get confusing, so it’s important to understand the basics and talk with your financial and tax professional if you or your student will be taking classes. In the meantime, you can read more about tax benefits for education in Publication 970.