Paying for College: Are Scholarships Taxable?

Dear Carrie,

My daughter was lucky enough to receive a significant college scholarship. Is this considered taxable income to her? And does her scholarship limit my ability to claim an education tax credit?

—A Reader

Dear Reader,

First congratulations to your daughter—and to you. Her scholarship can be a significant financial boost for both of you. And this is a great question because it touches on issues that both students and parents need to be aware of when filing tax returns.

First, the good news for your daughter is that scholarship money, for the most part, isn't taxable because it isn't considered income. The good news for you is that you still may be able to claim an education tax credit on your return as long as you pay qualified expenses above and beyond what your daughter's scholarship covers.

Of course, when it comes to taxes, there's rarely a simple yes or no answer. So before you start celebrating, let's look a little more closely at each situation.

Scholarships that are tax-free

According to the IRS, certain conditions must be met for a scholarship or fellowship to be tax-free:

• The student must be a degree candidate at an eligible educational institution, which generally means an institution with a regular faculty and curriculum and a regularly enrolled body of students.

• The scholarship or fellowship money is used for qualified expenses. This includes tuition and fees, books, and course- or degree-related costs (like supplies required for specific classes) but does not include other college-related costs such as room, board and travel.
• The money does not represent wages for teaching or other work.

That sounds pretty clear. However, for a scholarship to be completely tax-free, all the money must be used for qualified expenses. For example, if your daughter received a $10,000 scholarship and tuition was $15,000, she wouldn't owe taxes on the money. However, if her scholarship was $20,000 and $5,000 went for room and board, that $5,000 would be considered taxable income.

Scholarships considered taxable income

Now let’s say your daughter is a grad student with a fellowship that requires her to be a teaching assistant. In this case, the tax rules are different. That's because scholarship or fellowship money that represents compensation is taxable—regardless of how the money is used. So even if a $20,000 teaching assistant fellowship went primarily to pay for tuition and books, that $20,000 would still be considered taxable income. The student would receive a W-2 from the school and would have to file a tax return.

A couple of exceptions

These IRS rules apply to scholarships (both merit and athletic), fellowships and grants— including government-sponsored, need-based Pell Grants. However, there are exceptions.

For example, payments made through the GI Bill aren't considered scholarships, nor are they considered taxable income. Students participating in the National Health Service Corps Scholarship Program or the Armed Forces Health Professions Scholarship and Financial Assistance Program also don't generally pay taxes on their aid for qualified education expense. Student loans, of course, are never taxable since they aren't considered income, and have to be repaid.

And just to be very clear, scholarships awarded to students who are not in a degree program are always taxable.

How education tax credits fit in

Education tax credits, which directly reduce the amount of income tax you pay, could be another way to offset some of your daughter's qualified college expenses, depending on your own income. There are two possible credits available:

• American Opportunity Tax Credit (AOTC)—This credit allows an annual maximum credit of $2,500 per student for four years of undergraduate education. To qualify for the full credit, your modified adjusted gross income (MAGI) must be $80,000 or less ($160,000 or less for married filing jointly). The credit is phased out for taxpayers with incomes above these levels.
• The Lifetime Learning Credit (LLC)—This credit allows a maximum of $2,000 per year per tax return (not per student), but it can apply to undergraduate, graduate or professional degree courses, with no limit on the number of years. Income limitations are lower: in 2019 MAGI must be $68,000 or less for individuals ($136,000 or less for married filing jointly).

If you qualify for both credits, you must choose one or the other. You can’t use both.

Don't forget deductions

A tax deduction reduces your taxable income. Unfortunately one of the two previous deductions, the tuition and fees deduction, expired after the 2017 tax year.

However, if you are paying interest on a student loan for your daughter’s education, you may be eligible to deduct up to $2,500, provided your 2019 MAGI is less than $85,000 ($170,000 if filing a joint return).

Get the full details

This is just the topline information, but it should give you a good start. To make sure your situation falls within all the IRS parameters, go to irs.gov/uac/Tax-Benefits-for-Education:-Information-Center or consult IRS Publication 970: Tax Benefits for Education. Better yet, talk to your accountant or other tax professional. And best of luck to your daughter.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.