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Updated on Thursday, July 5, 2018
The cost of higher education can be astronomical for many students, and while there are many ways to pay for college, scholarships and grants are two of the best ways to make it more affordable. If you are awarded a scholarship, whether it’s merit-based or need-based, congratulations! However, the next thing to consider after receiving a grant is your tax liability on the money — not as much fun but nonetheless important.
Some scholarships and fellowships are tax-free, but some are subject to income taxes. We’ll walk you through the ins and outs of scholarship taxation and how to pay taxes on grants that are taxable.
When scholarships are not taxable
There are fellowship or scholarship grants that are tax-free, according to the IRS, and you don’t need to report them as a source of income, when you meet both of the conditions below:
- You are studying toward a degree at a higher education institution.
- All the funds you receive are used for qualified education expenses: You either use the money to pay tuition and fees required for enrollment or attendance at the college or university, or cover course-related expenses, such as textbooks, supplies and equipment.
For example, if you receive a $10,000 scholarship and pay it toward the $20,000 tuition, then you won’t owe taxes on the money. However, if your scholarship is $30,000 and you use $20,000 for tuition and cover your rent with $10,000, that $10,000 is taxable income.
Some other types of grants, such as Fulbright grants and need-based grants like a Pell Grant, are also treated as scholarship funds for purposes of determining their tax treatment: They are tax-free if grantees use them to cover qualified education expenses during the time when a grant is awarded.
April Walker, lead manager for Tax Practice and Ethics at the American Institute of CPAs, told MagnifyMoney that it doesn’t matter if a scholarship is granted by your school or sent to you directly from an organization — you follow the same rules above to determine whether it’s taxable or not.
When scholarships are taxable
However, grants should be included in your gross income if they are non-qualifying education expenses, meaning they don’t meet the conditions we just talked about.
Using scholarships for incidental expenses
The IRS explains that scholarship or fellowship funds that are used to cover incidental expenses are taxable. Incidental expenses are the money you spend for non-academic activities that are not required as part of your education, such as rent, insurance, transportation and living expenses.
Compensation for services
If students receive a scholarship or fellowship grant that requires them to be a teacher assistant, research assistant or perform other services, the funds are also taxable as salaries. There are exceptions, though. The IRS said grant recipients of the National Health Service Corps Scholarship Program and the Armed Forces Health Professions Scholarship and Financial Assistance Program do not have to include the scholarship funds they receive for service in their gross income.
Similarly, a grant or fellowship awarded to a non-degree-seeking individual to finance a certain research project, a report or a product is taxable, according to tax specialists interviewed by MagnifyMoney. But you could deduct expenses related to the work, such as travel and supplies for research, from your taxable income.
How to pay taxes on scholarships
Students should expect to receive a Form 1098-T that states their tuition and scholarship amounts from their schools by Jan. 31. If your tax-free scholarship or fellowship grant is your only income, you don’t have to file a tax return or report it, however, if part or all of the grant is taxable, then you are required to file a tax return, according to the IRS.
If the taxable amount wasn’t reported on Form W-2, enter “SCH” along with the taxable portion in the space to the left of the “Wages, salaries, tips” line. Form W-2 is the form an employer sends to an employee and to the IRS at the end of each year that reports an employee’s annual income and the amount of taxes withheld from their paychecks. Most likely, graduate students who perform teaching or research services at their institutions will receive a W-2.
Even if you don’t get tax forms, you must pay taxes on your scholarship income that’s subject to income taxes.
In general, the taxable amount of scholarships would be included in the adjusted gross income on the federal return, said Mark Luscombe, principal analyst at Wolters Kluwer Tax & Accounting. But depending on your state of residence and other incomes you have, you may also have to pay state income tax on your scholarship income, Luscombe said. Some states don’t have an income tax. Many states with an income tax use federal Adjusted Gross Income as the starting point in determining their state taxes, Luscombe said, and if your gross income is higher than your state’s income tax base, you will pay state income tax on your scholarship.
How can I minimize my tax burden from scholarships or fellowships?
Tax tips for students
Tax specialists advised if you’re a student, whether you are a dependent on your parent’s tax return or an independent student, you should keep track of the scholarships you receive and your qualified education expenses to make sure you spend as much of your scholarship as possible on qualified education expenses. Keep an eye out for a 1098-T, and in the case of graduate teaching assistants or research assistants, watch out for a Form W-2 at the end of the year.
If your scholarship doesn’t cover all your tuition and fees, Walker suggested you still keep track of your expenses, as some may qualify for education credits, which we will talk about below.
Tax tips for working professionals
For non-degree-seeking individuals who received a grant for an independent research project, Luscombe said they may want to treat the grant as a business income.
If you are running a business on your own, you’re most likely seen as a sole proprietorship owner for tax purposes. You will have to report business-related income and losses on a Schedule C (Form 1040) each year. Luscombe said grant awardees may claim the fellowship activity as a business activity on Schedule C to deduct the related expenses from their taxable income.
Under the new tax law, pass-through business owners can deduct up to 20% of their qualified business income from a partnership, S corporation or sole proprietorship. Individuals earning $157,500 or less ($315,000 for married couples) are eligible for the fullest deduction.
Luscombe advised those who received a one-off grant during the year keep separate records of all the income and expenses related to it.
Education tax credits
If part or all of your — or your child’s or spouse’s — scholarships are taxable, one of the ways for you to offset education expenses is to claim education tax credits, which reduce the amount of your income tax. There are two types of credits available: the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC).
- American Opportunity Tax Credit: This credit allows a taxpayer an annual maximum credit of $2,500 per undergraduate student of the costs for school or course-related expenses. Luscombe said AOTC is probably the most generous of tax breaks available for undergraduate education. To qualify for the full credit, your income must be $80,000 or less ($160,000 or less for married filing jointly). The credit is phased out for those whose incomes are above the thresholds.
- The Lifetime Learning Credit: It allows a taxpayer a credit of up to $2,000 per year per tax return. This credit applies to an eligible student’s costs for undergraduate, graduate or professional degree courses. There’s no limit on the number of years you can claim the credit. You must earn $66,000 or less ($132,000 or less for married filing jointly) to qualify for this credit. The credit is phased out for those whose incomes are above the thresholds.
To be eligible for either credit, students should receive a Form 1098-T. You also need to complete the Form 8863 and attach it to your tax Form 1040 or its variations. You cannot claim the credit if you are a dependent on someone’s tax return.
You cannot double dip if you qualify for both credits — you must compare options and choose one or the other. You cannot claim either credit if someone else claims you as a dependent on their tax return.
If you don’t qualify for either credit, you can look into potential tax deductions to reduce your taxable income. There are two deductions that may be applicable: the Tuition and Fees Deduction and the Student Loan Interest Deduction. You can claim these deductions even if you do not itemize your deductions.
The tuition and fees deduction allows you to deduct qualified higher education expenses of up to $4,000 from taxable income per tax return for yourself, your spouse or your child. You need to claim your qualified deduction on Form 8917. You cannot claim this deduction if your filing status is married filing separately or if someone else claims you as a dependent on their tax return. The income threshold for this deduction is the same as that for the AOTC. (Note: This tax break was supposed to expire at the end of 2016, but the Bipartisan Budget Act of 2018 renewed it for tax year 2017. It’s unclear whether it will be continued for tax year 2018.)
Student loan interest deduction: If your income is less than $80,000 ($165,000 if filing a joint return) and you took out a student loan to pay for qualified education expenses for you, your spouse or your dependent, you may reduce your taxable income by up to $2,500 of student loan interest you paid. You cannot claim this deduction if your filing status is married filing separately or if someone else claims you as a dependent. You should receive Form 1098-E, the Student Loan Interest Statement, which can help you figure out your student loan interest deduction.
You cannot claim the Tuition and Fees Deduction (if it’s available for tax year 2018) if you have claimed an education credit for the same expense, Luscombe said, but you can still claim the Student Loan Interest Deduction.