Scholarships and College Costs: Are They Taxable?

Scholarship funds are typically exempted from taxes as long as the recipient is enrolled in an authorized school and the funds are utilized to cover allowable costs.
For scholarships to be tax-free:

i. The student must be pursuing a degree in an approved educational institution, which is typically defined as one having a regular student body, faculty, and program.

ii. The money from a scholarship or fellowship is applied to eligible costs. This covers the cost of books, tuition, and other expenses associated with the course or degree (such as supplies and equipment needed for particular classes). It excludes additional expenses for travel, lodging, and board associated with attending college.

iii. Except in cases where specific scholarship programs call for services, the money does not constitute pay for labor such as teaching or other jobs.

Some scholarships have restrictions on what you can use the money for, so it’s good to know upfront if there are any restrictions on your scholarship money. Other scholarships have a wide range of allowable uses for the funds. However, allowable expenditures for a particular scholarship might not necessarily be the same thing as “qualified education expenses” for tax purposes — figuring it all out can get confusing.
That sounds pretty clear. However, let me reiterate that for a scholarship to be completely tax-free, all the money must be used for qualified education 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

Let’s now imagine that your daughter is a graduate student and that her fellowship calls for her to work as a teaching assistant. The tax regulations are different in this instance. That’s because funds from fellowships or scholarships that are intended to be used as pay are typically subject to taxes. The school would provide a W-2 to the student, who would then need to file a tax return.

There exist some exceptions

However, grants, fellowships, and scholarships (athletic and merit-based) are subject to IRS regulations, including the government-funded, need-based Pell Grants. There are certain exceptions, though.

For instance, money received under the GI Bill is not regarded as taxable income or a scholarship. In general, students who receive financial assistance for approved educational expenses through the Armed Forces Health Professions Scholarship and Financial Assistance Program or the National Health Service Corps Scholarship Program do not have to pay taxes on their aid. Naturally, since student loans are repaid and aren’t regarded as income, they aren’t taxable.

To be crystal clear, scholarships given to non-degree-seeking students are always taxable.

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 income. There are two possible credits available :

i. American Opportunity Tax Credit (AOTC): For four years of undergraduate study, this credit gives a maximum annual credit of $2,500 per student. Your modified adjusted gross income (MAGI) must be $80,000 or less ($160,000 or less for couples filing jointly) in order to be eligible for the full credit. For solo filers with incomes between $80,000 and $90,000 (between $160,000 and $180,000 for joint filers), the benefit gradually disappears.
ii.  Lifetime Learning Credit (LLC)—This credit allows a maximum of $2,000 per year per tax return (not per student), and it can apply to undergraduate, graduate, or professional degree courses, with no limit on the number of years. Income and phase out limitations are the same as for the AOTC ($80,000–$90,000 for single filers and $160,000–$180,000 for married filing jointly).

If you qualify for both credits, you must choose one or the other. You can’t use both tax credits on the same student in a single tax year.