Scholarships, grants and the FAFSA: what's taxable

A scholarship is tax free to the extent it pays for tuition and required course materials, and taxable to the extent it pays for anything else. What the money was called matters far less than what it was spent on.

The rule, and what is taxable

Two conditions have to hold for tax-free treatment. The student is a degree candidate at an eligible educational institution, and the money goes on tuition, on the fees that school requires in order to enroll or attend, or on the fees, books, supplies and equipment that the courses themselves demand. A third limb is the one readers forget: the award must not be set aside or labeled for anything else, housing and meals being the usual example, and it must not amount to wages.

The other side follows from the same rule. Money that ends up on incidental costs — a dorm room, meals, travel, equipment nobody required — becomes gross income, and so does anything the student earns by teaching, doing research or performing some other service the award demands in return. A narrow exception covers required service under the National Health Service Corps and Armed Forces Health Professions scholarship programs, and under a work college's comprehensive work-learning-service program, and it does not stretch to a campus job that happens to come with an award.

Where it goes on the return

If the taxable portion was reported to the student in box 1 of a Form W-2, it joins the wages total on the front of the return. If it was not reported on a W-2, it goes on Schedule 1 instead, and the student reports it whether or not any form arrived.

Who reports it is a narrower question than families assume. The scholarship is the student's income, not the parents'. Whether it has to be reported at all turns on two things: whether the student is required to file a return in the first place, and whether any of the award is taxable. A student whose entire income for the year is a scholarship that stays tax free throughout therefore usually files nothing and reports nothing. Who must file carries the thresholds that settle it.

The box 5 trap

A 1098-T where box 5 exceeds box 1 is what sends most families looking for an article like this one, because the difference looks like income waiting to be taxed. It usually is not, or not all of it. The form is a report from the college, and it does not tell you what the money was actually spent on, which is the only question the tax rule asks. Work that out from the bursar's account statement for each term, matching the charges against the credits, rather than subtracting one box from another. Reading a 1098-T goes through the form box by box.

Paying tax on part of it on purpose

This is the counterintuitive part, and it is worth real money to some families. Where a student deliberately reports part or all of an award as income for the year it arrives, the credit and the award can together be worth more than they would have been had the whole award stayed tax free. The mechanism is simple enough to state in one sentence: a scholarship that is allowed to cover living costs rather than tuition leaves the tuition unspent by tax-free money, and tuition that nothing tax free has paid for is what an education credit is figured on.

It helps a family whose credit would otherwise be squeezed out by a large award, and it does nothing for a family whose income already rules the credit out or whose student has no tax to speak of either way. Education credits covers the credits themselves; the arithmetic of the trade is a conversation to have with a preparer before the return is filed, not after.

The FAFSA is not the tax return

The financial aid form and the tax return ask different questions, so the numbers they produce are different numbers and are not meant to line up. Nothing in this article tells you how an award will be treated for aid purposes, because that is a separate system with its own definitions. A tax article cannot answer an aid question, and the college's financial aid office is the right place to take one.

Estimated tax, and what to keep

If part of the award is taxable, nothing has usually been withheld from it, so the tax may have to be paid in during the year through estimated payments. Keep the bursar's account statement for every term, the award letters that say what each award was for, and the receipts for books and equipment the courses required. Those three things are what turn a disputed number into a documented one, years later.