Understanding the Tax Rules for College Scholarships

Receiving a college scholarship is exciting news for many students and their families. Scholarships, grants, and other forms of financial aid can significantly reduce the cost of higher education. However, many families are surprised to learn that not all scholarship funds receive the same tax treatment.

While many scholarships are entirely tax-free, certain portions may be taxable depending on how the funds are used. Understanding these rules before the school year begins can help families avoid unexpected tax consequences and make more informed decisions when coordinating scholarships with other education benefits.

When Scholarships Are Generally Tax-Free

Scholarships and fellowship grants are generally tax-free when received by a degree candidate at an eligible educational institution and used for qualified education expenses.

Qualified education expenses generally include:

• Tuition
• Required enrollment fees
• Required books, supplies, and equipment

The key distinction is that these expenses must be required by the educational institution or course of study. Scholarship funds used for these purposes are generally excluded from taxable income.

When Scholarship Funds May Be Taxable

Not all education-related expenses qualify for tax-free treatment. Scholarship funds used for personal living expenses are generally considered taxable income.

Examples of expenses that may result in taxable scholarship income include:

• Room and board
• Rent and meal plans
• Travel expenses
• Optional equipment or supplies
• Living stipends and similar allowances

In addition, compensation received for services, such as teaching, research, or other employment performed as a condition of receiving financial assistance, may also be taxable.

Because scholarship awards often cover multiple types of expenses, families should carefully track how the funds are allocated throughout the academic year.

Understanding Form 1098-T

Most colleges and universities issue Form 1098-T, Tuition Statement, to both the student and the IRS. The form provides information about qualified tuition payments and certain scholarships or grants received during the year.

Although Form 1098-T is an important tax document, it does not always provide all the information necessary to determine whether scholarship funds are taxable. For example, it generally does not identify how scholarship funds were ultimately used or include every source of financial assistance a student may receive.

As a result, students and families should maintain their own records of education expenses and financial aid throughout the year.

Coordinating Scholarships with 529 Plans

Families using both scholarships and 529 plans should also consider how the two benefits interact.

Qualified withdrawals from a 529 plan can generally be used for a broader range of education expenses than scholarships. For example, 529 plan distributions may generally be used tax-free for eligible room-and-board expenses when the student is enrolled at least half-time, subject to applicable limits. Distributions may also be used for computers, certain software, related equipment, and internet access used primarily by the beneficiary while enrolled at an eligible educational institution.

Carefully coordinating scholarship funds with 529 plan distributions can help maximize available tax benefits and reduce the likelihood of unexpected taxable income. Families should also avoid using the same education expenses to support both a tax-free 529 plan distribution and another education-related tax benefit, such as an education tax credit.

Planning Considerations

Families preparing for the upcoming school year should consider several tax planning questions, including:

• Which education expenses qualify for tax-free scholarship treatment
• Whether scholarship funds are being used for qualified or nonqualified expenses
• How scholarships interact with 529 plan withdrawals and available education tax credits
• Whether adequate documentation is being maintained to support the tax treatment of financial aid

Reviewing these issues before tuition payments are made can help avoid surprises when it comes time to prepare the family’s tax return.

How LMC Can Help

Education funding can involve complex tax rules. At LMC, we help individuals and families understand the tax implications of scholarships, 529 plans, and other education-related benefits. Contact your LMC advisor with any questions.